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Consumer Surplus, Fundamental Welfare Theorems and Revealed Preference Approach

Sergey A. Moskalionov* Department of Economic Theory Ulyanovsk State University

Tel.: +7 (8422) 320697 email: moskalionov@mail.ru

Last version: January 2008

Author is indebtful to Richard Ericson (scientific advisor of research), Viktor M. Polterovich and Jiandong Ju for very helpful comments and advices and also participants of December 2003, July 2004, December 2004, December 2005 EERC workshops, participants of April 2007 and April 2008 Higher School of Economics International Conferences in Moscow for discussions and recommendations. We also thank Konstantin Sonin, Alexey Savvateev and Sergey Kovalev for critical suggestions. Financial support from Human Capital Foundation (Contract 18) and Economics Education and Research Consortium of Eurasia Foundation (Grant R03-1421) is gratefully acknowledged. All remaining mathematical and English language mistakes our full responsibility.

Electronic copy available at: http://ssrn.com/abstract=1093715

Abstract

The paper shows that change in the aggregate Marshallian surplus change in the sum of all consumers net surpluses and incomes is a correct measure of efficient social welfare (function) for any adjustment path with fixed unitary price of numeraire if preferences of normative representative consumer are quasilinear with respect to some commodity and it is correct efficient social welfare measure for general class of consumer preferences along adjustment path when social welfare function that supports a sequence of equilibria is changing monotonously and along adjustment paths with constant social marginal utility of total income and constant individuals marginal utilities of income. Fundamental welfare theorems are proposed to generalization for potential application of aggregate Marshallian surplus measures and the relation between aggregated revealed preference approach, Coase theorem, fundamental welfare theorems and representative consumer approach is discussed.

Keywords: consumer surplus, aggregation, fundamental welfare theorems, Coase theorem, revealed preference, equilibrium representative consumer JEL codes: D12, D51

Electronic copy available at: http://ssrn.com/abstract=1093715

1. Introduction
Beginning from Dupuit (1844), developed in Hicks (1939) and elsewhere, consumer surplus concept was one of the most old and extensively discussed notions in the economic analysis. It has attractive applied value and a simple expositional beauty. Consumer surplus is applied in traditional cost-benefit analysis, international trade analysis, partial equilibrium welfare analysis, tax reform evaluation the scope of application is enormous (see Currie et al., 1971 for an early survey of applications). However, the consumer surplus conception have been rigorously applied so far only in the quasilinear case, when marginal utility of income is constant and equal to unity. Quasilinear preferences imply that demand for all other goods except numeraire (which price should be normalized to unity) should be independent from consumer income changes a very strong assumption indeed1! A bunch of criticism towards consumer surplus concept had essentially narrowed the possible field of its direct theoretical and practical application. However, in the recent paper Ju (2002) tried to show that there is efficient social welfare indicator that represents Walrasian equilibrium and unavoidably coincides with a sum of consumers Marshallian surpluses and incomes. In other words, he argues that the change in the sum of consumers surpluses and incomes represents potential Pareto-improvement if this sum is positive, and any actual Pareto-improvement implies that this sum should be non-negative. The change of this Marshallian social welfare measure is path dependent in general, but is path independent for some special class of consumer preferences. Common point of view in economics is that, as it was stated by Chipman and Moore (1976), consumer surplus should be path independent (in a full space of adjustment paths) to serve as a specific cardinal utility measure2. Because consumer surplus is defined as a line integral, the value of this integral generally depends on the path of integration and, as a result, they argue, consumer surplus can be correct individual utility measure only for some special types of consumer preferences. Other usual criticism towards Marshallian surplus measure is that generally marginal utility of income is not constant and even can not be constant along any variety of prices and income (what was shown by Samuelson (1942)) and from Antonelli (1886) equations (or Roys identity) it follows that generally Marshallian surplus can not represent change in consumer utility.

Samuelson (1942) called the restrictions of preferences needed for consumer surplus to be relevant concept as highly unrealistic. 2 They claimed: That consumers surplus should provide a particular cardinal measure of a consumers welfare seems obvious to us, in view of its use in making policy recommendations. But it should be pointed out that this point of view has been specifically rejected by Harberger (1971, pp. 788-79), apparently on the ground that there is something illegitimate about adopting a particular numerical utility index to measure satisfaction, Chipman and Moore (1976, p. 77).

4 We do not argue that consumer surplus by itself is a utility function3. In this paper we confirm and develop Chipman and Moore (1976) and Zajac (1978) results and show that a change in the sum of Marshallian net surplus and consumer income is a correct individual welfare measure for general type of consumer preferences when and only when the integral is calculated along (piece-wise) monotonous adjustment path, i.e., along path with (piece-wise) monotonously changing utility function or along paths with constant marginal utility of income and it is correct measure of individual welfare along any adjustment path with unitary price of numeraire if and only if consumer preferences are quasilinear with respect to numeraire. Similar result is obtained for the aggregate Marshallian surplus: the sum of all consumers net surpluses and incomes is correct measure of social welfare for any equilibrium adjustment path with unitary price of numeraire if preferences of equilibrium representative consumer are quasilinear with respect to this commodity and it is correct social welfare measure for any type of consumer preferences along monotonous adjustment path: when efficient social welfare function that rationalizes a sequence of equilibria is changing monotonously along path or along adjustment paths with constant social and individual marginal utilities of income. The paper is organized as follows. In the second section we provide a survey of literature on consumer surplus and social welfare measurement. In the third section we analyze the relevance of consumer surplus concept for individual utility measurement. In this section we reconstruct and reinterpret Ju(2002) multi-step tax adjustment technique and demonstrate again the relation of Marshallian surplus measure to the Strong Axiom of Revealed Preference. In section four we discuss aggregated Marshallian social welfare measure that introduced by Ju (2002). In the sixth section we show irrelevance of the use of standard aggregated revealed preference approach for the evaluation of the results of economic reforms and provide income redistribution example. In the seventh section we generalize Coase Theorem, fundamental welfare theorems and show their relation to the normative representative consumer analysis and social welfare measurement. Final section concludes.

2. Survey of the Literature


Dupuit (1844, reprinted in 1969) had assumed that demand curve coincides with marginal utility schedule, from this consumer surplus (CS) concept was naturally derived. This assumption im-

plied constant marginal utility of income. Marshall (1890, pp. 740-741) had argued that marginal utility of income is generally changing, but that we can easily abstract from this, as such change is
3

It would be better to claim that correctly defined consumer surplus is change in utility, analogy of specifically defined binary function. See Zajac (1979) for further discussion. See our preliminary analysis in Moskalionov (2007a and 2007b).

5 of the second order of smallness. However, Pareto (1892) and Samuelson (1942) had clearly shown that it is never possible that marginal utility of income can be constant along any variety of prices and incomes. Path-dependence property of consumer surplus integral was recognized and discussed in economics long ago, see Hotelling (1938), Silberberg (1972), Burns (1973) among others. Burns (1973, p. 340) was first to propose calculation of consumer surplus along piecewise monotonous adjustment path, but he did not discuss relation between this approach and path-independence theory. Silberberg (1972) derived necessary and sufficient conditions (somewhat informally) for the respective line integral to be path-independent along adjustment path. These authors considered path dependence as a problem, but they did not claim that CS should be path independent. Another line of research was initiated by Chipman and Moore (1976, 1980a), who confirmed and extended results of Pareto (1892) and Samuelson (1942). They considered a vector-valued function f of prices and income and constructed the line integral of this function over the space of price-income pairs (budget space) connecting state 0 and state 1. They investigate a question: what properties should be satisfied by this function in order that the line integral or CS can be correct cardinal measure of individual consumer utility. They worked in the budget space with direct demand functions, indirect preferences and indirect utility functions. Results of Chipman and Moore research were not very promising. They argued that if there is no restriction in the budget space or in the space of consumers preferences, then it is never correct to use consumer surplus as individual utility measure because CS should be path-independent but it is generally path dependent. This is true also if we do not have restriction in the space of adjustment paths. Then they argued that if the first N (number of goods) components of f are functions of prices alone, the line integral is path-independent if and only if consumer preferences are homothetic. If the last N com ponents of the function f are restricted to be functions of the prices alone, the specified line integral can be path-independent if and only if consumer preferences are quasilinear with respect to the first good. This case corresponds to Hicks (1942) analysis. These restrictions are rather strong indeed: empirical research do not support the hypothesis that consumers preferences are homothetic or quasilinear. In the first case marginal utility of income should be independent from of prices and in the second case it should be independent on income and of all prices other than that of commodity 1. If there is restriction in the budget space in the choice of starting and ending points, ex. if income do not changes, then specified line integral can be path-independent if and only if consumer preferences are homothetic. And if price of the first good does not change along the adjustment path, then the specified line integral can be path-independent if and only if preferences are quasilinear with respect to the first good. Chipman and Moore (1980a) had received similar results for the Hicksian

6 surplus defined as a line integral of the Hicksian compensated demand function. In our project we do not just replicate Chipman and Moore (1976) results, we provide a specific solution for the path dependence problem following Burns (1973), Zajac (1979) and Stahl (1980, 1983). Zajac (1979) and Stahl (1980) introduced a notion of monotonic variation as a space of CS along subset of monotonous adjustment paths; they proved that such measure is order- or preference-preserving4. Stahl (1983) constructed a space of paths resulting in compensating (equivalent) variations along which CS is path-independent. We are developing similar result independently from their research, also reconstructing Ju (2002) multi-step tax adjustment scheme and show relation of such measure to the path dependence problem. Let us go the social welfare theory developed by the New Welfare Economics. The major idea was to extend Pareto principle beyond the field of obvious application without involving any interpersonal comparisons of utility. The compensation principle actually was originally introduced in Kaldor (1939): state 1 is socially better than state 0 if gainers can compensate in some way losers such that everybody will be better off in state 1 (or at least as well off as in state 0)5. Alternative criterion was proposed by Hicks (1939): state 1 is better than state 0 if losers would not be able to bribe the winners into not undertaking the move to the state 1. Later these criteria were implemented in the original cost-benefit analysis as a sum of compensating or equivalent variations (see Mishan, 1972). Following Foster (1976), we identify two types of Kaldor criteria: strong Kaldor criterion requires redistribution of new aggregate consumption bundle between consumers without change in production and is defined through Scitovsky set (see definition of this set in Samuelson, 1956 versus Blackorby and Donaldson, 1990); and weak Kaldor criterion involves costless lump sum income transfers between agents with changes in aggregate production. (In our project we consider weak version of Kaldor-Scitovsky-Samuelson criterion, or potential Pareto improvement criterion (PPI), to be defined below.) However, Scitovsky (1941) had recognized symmetry, or reversals in original Kaldor criterion, and as a way out of the problem proposed double criterion (actually combining Kaldor and Hicks criteria), later known as Scitovsky criterion. This did not help a lot. Gorman (1955) identified generic intransitivity in both Kaldor and Scitovsky criteria. Summarizing results of his research (Gorman, 1953, 1955, 1961), we receive that Kaldor-Scitovsky criterion is acyclic when and only when there exists positive representative consumer, and if there is no restriction in the budget space, such aggregate consumer exists when and only when preferences of each consumer are of Gorman type (quasihomothetic)6. This is a very restrictive assumption indeed7.

Stahl (1983, p. 95) argues: logical conclusion is that any a priori restriction on the admissible paths of integration that yields an order-preserving index is legitimate. In addition to the family of expenditure functions indices, monotonic variation satisfies this principle. 5 The idea had been intimated by Barone (1908, pp. 255-256) and Viner (1937, pp. 533-534). 6 For more criticism against representative consumer approach, one can look at Kirman (1992).

7 Gorman result was later developed in the number of famous exact aggregation theorems, see Eisenberg (1961), Lau (1982), Jorgenson et al. (1982), Lewbel (1989), in the Russian literature similar results (in light of index number theory) were presented in . (Petrov et al.) (1996) and (Shananin) (1986). Little (1949, 1957, p. 103) and later Mishan (1963, 1965, 1969) had introduced distributional judgements into compensation criteria, however, their criteria were strongly criticized my numerous authors8. A possible way out from Gorman intransitivity is in Samuelson (1950) criterion, which was called in Chipman and Moore (1971, 1973, 1978) Kaldor-Hicks-Samuelson criterion. This criterion proposes that state 1 is better than state 0 if all possible redistributions in state 1 will achieve utility allocations that are superior to some possible redistributions in state 0 and that no possible redistribution in state 0 will yield utility allocations that are unachievable through some possible redistributions in state 1. This criterion implies that utility possibility frontiers should not intersect and, of course, it is transitive but incomplete measure on a full space of social states9. In our paper we consider Marshallian measure that will induces Samuelson criterion on some subspaces of social states as pure measure of economic efficiency, in line with weak Kaldor approach. Another realization of compensation principle was aggregate willingness to pay measure, or a sum of compensating variations (or CV) (Mishan 1971, 1972, Dasgupta and Pearce 1972). This is a separate criterion, and it was strongly criticized by Boadway (1974), who had shown that positive sum of compensating variations is not sufficient condition for PPI defined as strong Kaldor criterion. Foster (1976) later provided illustrations claiming that positive sum of CV is necessary but not sufficient condition for both, strong and weak, versions of Kaldor criterion10 and that in case of price distortions, positive sum of CV is not necessary for the weak Kaldor criterion11. For a more formal representation of these results for strong Kaldor criterion, one can refer to a nice survey by Blackorby and Donaldson (1990). Roberts (1980a) and Blackorby and Donaldson (1985) have shown that positive sum of CV generates complete ordering of efficient equilibria when and only when exists positive representative consumer12 in line with Gorman (1953) result13. All these
7

Even this strong restriction is not enough to provide correct Pareto ranking of inefficient equilibria, see Blackorby and Donaldson (1990, p. 487). 8 See good criticism in Chipman and Moore (1978). Harberger (1978) gives an informal discussion of introducing distributional weights into traditional cost-benefit analysis. 9 Arrow and Scitovsky (1969, p. 385) had criticized Samuelson approach as purist approachnot fully accepted by the profession. However, Chipman and Moore (1978, p. 579) claim that it provides a basis for recommending policies leading to efficient and Pareto optimal organizations of the economy. In short, it provides the only logically defensible basis for the New Welfare Economics that is available". 10 Mishan (1976) criticized Boadway (1974) paradox claiming that he had used not the true compensating variation measure. His defense was not very satisfactory. 11 Similar results for the move from distorted equilibrium to competitive equilibrium were proved by Schweiser (1983) and Diewert (1985). 12 Ruiz-Castillo (1987) have shown that non-negative sum of compensating variations is necessary condition for Kaldor-Hicks-Samuelson criterion to be satisfied, and sum of CVs criterion is equivalent to Kaldor-Hicks-Samuelson criterion when and only when all agents have identical homothetic preferences.

8 problems with compensation principle leaded Chipman and Moore (1978, p. 548) to the statement that New Welfare Economics must be considered a failure. Is it true? All these reversals and paradoxes are intimately connected with generic impossibility theorems by Arrow (1963), Kemp and Ng (1976), Parks (1976) and others claiming that generally it is impossible to aggregate individual rational preferences into the social preference relation if the latter satisfies several well known properties. To achieve aggregation, either assumption of rationality should be relaxed and social indicator will be acyclic or quasitransitive (not the best approach), or domain of admissible individual preferences should be narrowed (as in the example of single peaked preferences), or some degree of interpersonal comparability or cardinality should be assumed (as in Sen (1977), Roberts (1980b), see also nice survey in Sen (1986)). Aggregate consumer surplus as a social welfare indicator was discussed in several papers. Rader (1976) has shown that if each consumer preferences are homothetic and income distribution is fixed, then aggregate Marshallian surplus generates a social preference relation that can be represented as Eisenberg (1961) social utility function. Slivinski (1987) and Blackorby and Donaldson (1999) papers actually have reproduced classical Chipman and Moore (1976) results for the aggregate Marshallian surplus measure, both papers assume that CS should be path-independent and they did not consider restriction in the space of adjustment paths as we do in our project. Results of these papers are similar. Slivinski (1987) gives conditions, under which specified aggregate surplus is consistent with logarithmic (or Cobb-Douglas) social welfare function (SWF) if consumers preferences are homothetic, and is consistent with utilitarian SWF if consumers preferences are quasilinear with respect to the same good, on some subset of the space of social states (in both cases CS is path-independent). When only aggregate information is available, aggregate surplus is Paretoconsistent social welfare indicator when and only when each consumer preferences are of Gorman type. Blackorby and Donaldson (1999) have shown, first, that if there is no restriction in the aggregate budget space, then it is never possible that aggregate CS will be path-independent (reproducing Chipman and Moore results). They also considered different price normalizations14. If all prices are divided by income, the aggregate CS is path-independent when and only when all agents preferences are quasi-homothetic and an aggregate consumer exists; if the sum of all prices is equal to one, then it is never possible that CS will be path-independent. Finally, if numeraire price is normalized to unity, then aggregate CS is path-independent when and only when consumers preferIn the recent paper, Keenan and Snow (1999), provided interesting positive result: state 1 is Kaldor superior (in strong sense) to state 0 if and only if sum of compensating variations is positive for all efficient redistributions of new consumption bundle in state 1. Then, the set of allocations 1 is Samuelson superior to the set of allocations in the state 0 if and only if for all possible efficient redistributions in state 0 and in state 1 a sum of compensating variations is positive. The same results are proved for equivalent variations and compensating and equivalent surplus introduced by Hicks (1943, 1956). 14 Blackorby and Donaldson (1999) relate CS to the cost-benefit criterion that evaluate a project through the project output vector weighted with average before- and after project output prices.
13

9 ences are quasilinear with respect to numeraire15. In our paper we follow another line of research, we will analyze aggregate Marshallian surplus for a specific subspace of (piecewise) monotonous adjustment paths following Zajac (1979) and Stahl (1980), 1983). CS defined along monotonous adjustment paths is equivalent to the generalization of the marginal or differential real (national) income approach. Original ideas on a relation of the marginal increase of the real national income to the change in the social welfare were proposed in Bergson (1938, pp. 331-332) and Samuelson (1950, p. 16, footnote 2)16. Later it was developed in the classical literature on the cost-benefit

analysis of the small projects (Bruce and Harris, 1982). Bruce and Harris (1982) considered differentially small projects and claimed that a positive value of the marginal output vector of the project evaluated with shadow prices (in efficient economy they coincide with market prices) is necessary and sufficient condition for the weak version of compensation test. This result has direct relation to our aggregate Marshallian surplus measure. However, Bruce and Harris (1982) did not consider the problem of Pareto comparability or measurability of equilibria, the topic to be discussed in the future research. For differential social welfare analysis, see also Boadway (1976) and Laffont (1996) among others. Finally, in our paper, by reconstruction of Ju (2002) multi-step tax adjustment scheme, we show again that the Marshallian surplus measure for individual consumer is essentially continuous analogue of the strong axiom of revealed preference (defined along some subspace). The weak axiom was introduced by Samuelson (1938, 1947, 1948) and strong axiom was proved by Houthakker (1950)17.

3. Marshallian Surplus as a Correct Money Metric Individual Welfare Measure


Let assume, that we have H consumers, h = 1,...H and N goods, i = 1,...N . We denote consumption

of the good i by consumer h in social state indexed by t as xih (t ) . Consumption bundle of consumer h in state t is x h (t ) and consumption allocation is x (t ) = ( x1 (t ),... x H (t )) . Each consumer is endowed with income y h (t ) and y (t ) = ( y 1 (t ),... y H (t )) is a vector of incomes in state t, in production economy these incomes are just endowments of numeraire (by assumption, good k is numeraire: pk (t ) 1 t [ 0,1] ). Price vector denoted as p (t ) = ( p1 (t ),... p N (t )) . Aggregate demand is a sum of
Bergson (1980) had considered Hicksian approach: the aggregate CS as a sum of compensating or equivalent variations and also analyzed restrictions that would allow the use of CS as a representation by Bergson-Samuelson SWF. Importance of his paper consists in the analysis of inter-agent income transfers. 16 Discrete increase in the real national income is not sufficient for the potential Pareto improvement, see Samuelson (1950), Chipman and Moore (1971, 1973, 1978, 1980b), Laffont (1996). Montesano (2007) claims that generally it is also not necessary condition for potential Pareto improvement in production economy (but it is necessary condition in pure exchange economy). 17 For a continuous approach to the WA, see Kihlstrom, Mas-Colell and Sonnenschein (1976).
15

10 individual demands: X ( p(t ), y (t )) := h =1 x h ( p(t ), y h (t )) .


H

Consumers

utility

functions

u( x ) = (u1 ( x1 ),...u H ( x H )) are assumed concave, increasing in all arguments and continuously differentiable, whenever convenient. Also we assume that production functions X i = f i (l i ) are quasiconcave and continuously differentiable ( l i is labor in the production of good i), social welfare functions W (u ) are concave, increasing on all arguments and continuously differentiable. The state of economy, or social state, is a tuple ( p, x, y ) such that
H

( p, x )

is Walrasian equilibrium

or disequilibrium for the economy H , N , ( R h ) , y . We denote full set of potential states in the h =1 economy with fixed consumer preferences ( R h ) as S := {s = ( p, x, y ) N NH H } such ++ h =1 that each
H

( p, x )

is Walrasian equilibrium or disequilibrium for the economy H , N , ( R h ) , y , h =1


H

where H , N , ( R h ) are fixed and y are varying for different s, for given s they are fixed. h =1 Now we discuss parameterizations in our project. Adjustment path is a (piecewise) smooth C 2 parameterization : [ 0,1] S . A full space of parameterizations, or (piecewise) smooth C 2 paths

: [ 0,1] Sl (where Sl is a subset of S ) will be denoted as (Sl ) . This space can be endowed
with the C 2 topology (see Mas-Colell, 1985, p. 50-51, 344) and contain several subspaces, to be defined below. A path : [ 0,1] Sl connects two social states s and s if (0) = s and

(1) = s , we denote such path as ( s , s ) . A space of paths that connect two states: s and s we
denote as ( s, s ) . Let us consider directed continuous smooth curve ( p (t ), x h (t ), y h (t )) generated by adjustment path

(t ) defined on state interval [0,1] . This curve is smooth 1-dimensional compact manifold with
boundary (see Guillemin and Pollack, 1974). The consumers optimization problem has standard first order conditions:

t u h ( x h (t )) = h p(t )
where h is consumer h Lagrange multiplier, we consider only interior solutions. Antonelly equation (Roys identity) is applied in a standard way. Chipman and Moore (1976) and Ju (2002) propose, that change in generalized Marshallian consumer surplus for consumer h from state 0 to state 1 or Marshallian surplus by itself for this change can be calculated as integral:
CS (0,1) = y (1) y (0) i =1
h h h N pi (1)

xih (t )dpi (t )

(1)

pi (0)

11
= y h (1) y h (0) i =1 xih (t )
N 0 1

dpi (t ) dt dt

(2)

= y h (1) y h (0) i =1
N

xih (t )dpi (t ) = CS h ( ( s, s )),

( s , s )

if (0) = s and (1) = s . The integral over total adjustment path is just a sum of integrals over two subsequent segments of this path. First part of (1) and (2) shows change in nominal income, or value of endowment. Second part, integrals, shows the so-called change in net consumer surplus, or net surplus by itself18. We show that if consumer preferences do not change, such Marshallian measure is a correct individual welfare or utility measure for any piece-wise smooth adjustment path that generate monotonous utility adjustment path or path with constant marginal utility of income. Notice that generally consumer surplus is path-dependent along different monotonous paths connecting states 0 and 1 but it is every time equal to zero if monotonous path is closed, i.e. when it is returned to the original state 0. After Ju (2002) we propose that the change in Marhallian money metric social welfare measure is equal to:
CS (0,1) = h =1 y h (1) h =1 y h (0) i =1 X i (t )
H H N 0 1

pi (t ) dt t

= Y (1) Y (0) i =1 X i (t )
N 0

pi (t ) dt t
H

(3)

= Y (1) Y (0) i =1
N

( s , s )

X i (t )dpi (t ) = CS ( ( s, s )) = CS h ( ( s, s ))
h =1

The interpretation of (3) is approximately as follows: first part shows change in the social welfare due to the change in the aggregate value of endowments (social income) and second part (integrals) is deflating factor that clears the first component from inflation or deflation19. Notice that individual surplus is not utility function in simplest cardinal interpretation, but, is utility measure measure of utility change, and social surplus does not generate social welfare function generically (see further discussion), but generates social welfare measure (along specifically defined paths this measure is equal to change in social welfare function). See discussion below. Using change of variables, one can easy show that individual Marshallian surplus measure and social Marshallian surplus measure can look as follows:

18

In ordinal theory of surplus, it does not matter, do we call some measure surplus, or change in surplus. Such difference has sense only in cardinal interpretation. 19 Notice that a rise in the total endowment of numeraire usually results in the increase of the other goods prices.

12
CS h (0,1) = i =1 pi (t )
N 0 1

dxih (t ) dt dt dX i (t ) dt dt

(4)

CS (0,1) = i =1 pi (t )
N 0

(5)

Definition. An adjustment path : [ 0,1] Sl is social monotonous adjustment path (resp. monoto-

nous adjustment path for consumer h) if marginal Marshallian social welfare measure defined by

CS (t ) / t = i =1 pi (t )X i / t
N N

has

constant

sign

along

closed

interval

[0,1] :

CS (t ) / t = i =1 pi (t )X i / t > 0, or < 0, or = 0 for t [ 0,1] (resp. if marginal Marshallian


measure for consumer h CS h (t ) / t = i =1 pi (t )xih / t has constant sign along interval [ 0,1] :
N

CS h (t ) / t = i =1 pi (t )xih / t > 0, or < 0, or = 0 for t [ 0,1] ).


N

We denote such path as

m (S l ) (resp. mh (S l ) ). Full space of such defined paths we denote as m (Sl ) (resp. mh (S l ) ).


Adjustment path : [ 0,1] Sl is piece-wise monotonous social adjustment path (resp. piece-wise monotonous adjustment path for consumer h) if there is a partition M>1, of the closed interval
N

([t

, tm +1 ])m =1 , t1 = 0 , tM = 1 ,

[0,1]

such that

M = M1 M 2 ,

M1 M 2 = , and

CS (t ) / t = i =1 pi (t )X i / t > 0, or < 0 for t ( tm , tm+1 ) with m M 1 and for t ( tm , tm+1 )

with CS (t ) / t = i =1 pi (t )X i / t = 0 m M 2
N

(resp.if CS h (t ) / t = i =1 pi (t )xih / t > 0, or < 0 for t ( tm , tm+1 ) with m M 1 and


N

CS h (t ) / t = i =1 pi (t )xih / t = 0
N

for t ( tm , tm+1 )

with m M 2 ). For sure, partitions

([t

, tm+1 ])m=1 for social path and for consumer h should be taken independently from each other. In

other words, path is piece-wise monotonous if on some segments marginal Marshallian measure has some constant sign, on other segments it is zero. If it has constant sign everywhere, we have monotonous adjustment path. We denote such path as pm (Sl ) (resp. pmh (Sl ) ). A space of such defined piece-wise monotonous social adjustment paths is pm (S l ) (resp. space of piece- wise monotonous paths for consumer h pmh (S l ) ). Adjustment path : [ 0,1] Sl is non-monotonous if it is neither monotonous nor piece-wise monotonous. We denote such path as nm (S l ) (resp. nmh (S l ) ). A space of such defined nonmonotonous paths for society is nm (S l ) and for consumer h is nmh (S l ) .

13 Adjustment path : [ 0,1] Sl is closed social adjustment path if we have (0) = (1) for society and it
h

is

closed

adjustment

path

for

consumer

if

( p(1), x

(1), y h (1), h (1) ) = ( p (0), x h (0), y h (0), h (0) ) for consumer h. We denote it as c (S l ) for

society and ch (Sl ) for consumer h. From the above definition it is naturally flowing that for each Sl : (Sl ) = m (Sl ) pm (Sl ) nm (Sl ),

m (Sl ) pm (Sl ) = , m (Sl ) nm (Sl ) = , nm (Sl ) pm (Sl ) =


By analogy, we have:

(Sl ) = h (Sl ) = mh (Sl ) pmh (Sl ) nmh (Sl ), mh (Sl ) pmh (Sl ) = , mh (Sl ) nmh (Sl ) = , nmh (Sl ) pmh (Sl ) = h H
Notice that full space of social paths coincides with a full space of paths for each consumer h, because adjustment path by itself is defined for consumer and at the same time for society; only definitions of path monotonicity for society and consumer are different. If we are in partial equilibrium setting, then adjustment path for individual h can be defined differently from what is defined above for the social paths (see Chipman and Moore 1976), as in the above discussion we were only in general equilibrium setting.
Definition. CS integral is path-independent for society (resp. for consumer h) if for any two differ-

ent paths connecting any two social states: 1 ( s, s ) ( s, s ) , 2 ( s, s ) ( s, s ) , 1 2 , we have: CS ( 1 ( s, s )) = CS ( 2 ( s, s )) (resp. CS h ( 1 ( s, s )) = CS h ( 2 ( s, s )) ). To show welfare meaning of Marshallian surplus for (piecewise) monotonous paths, we may first reconstruct and reinterpret multi-step tax adjustment technique, proposed in Ju (2002) for a set of consumers. Let assume that we move from state 0 to state 1 and let introduce partition 0 = t0 < t1 < ... < t M = 1 of the state interval [0,1] and let xih (t m ) be consumption of the good i by household h at state tm for m = 1,2,..., M . As in Ju (2002), let tm =
m . Government can implement M

specific tax policy at each state t m such that consumer would be returned to the utility level at state
tm 1 if he will pay a specific commodity tax x (m) and an income tax y ( m ) as in the following

scheme:

x (m) = p(tm 1 ) p(tm )


y ( m ) = y ( t m ) y (t m 1 )

14 at each state tm for m = 1,2,..., M . After these taxes are paid, consumer will face commodity prices p(tm 1 ) and income y (tm1 ) instead of current equilibrium prices p(tm ) and income y (tm ) in state tm . As a result, consumer will be returned to the state tm1 and attain utility level as in the state tm1 . Applying this replication technique for all M time states, government can shift consumer back by one small time interval such that at the state t1 he will be in the same position as at the state t0 , at the state t2 - the same as at the state t1 , and so on. Let now calculate tax payments of consumer h at time state tm :

R h (tm ) = y h (t m ) y h (t m1 ) + i =1 ( pi (tm1 ) pi (t m )) xih (tm1 )


N

Total tax payments over all M time states will be TR h = m=1 R h (tm ) = y h (1) y h (0) m=1 i =1 ( pi (tm ) pi (tm1 )) xih (tm1 )
M M N

If number of steps M approaches infinity and tm tm 1 0 , the term pi (tm ) pi (tm 1 ) will converge to dpi (t ) . Then we apply definition of definite integrals and deduce that if number of steps approaches infinity, the sum of tax payments over state interval [0,1] converges to the sum of change in consumer income and Marshallian surplus:
w h (0,1) = y h (1) y h (0) i =1
N pi (1)

h i

(t )dpi (t )

pi ( 0 )

Can we argue then, (as Ju (2002) did for the set of consumers) that if continuous flow of tax revenue over state interval [0,1] , or Marshallian measure w h (0,1) is positive, then consumer is strictly better off in state 1 compare with state 0? The answer is: generally no. Exactly, let assume that we are in state 1 and government want to return consumer back to the state 0. Then it simply should impose commodity and income tax scheme such that consumer set back directly to the state 0. Then, if government tax revenue is positive in this case, it means that old consumption bundle x h (0) measured by new prices is cheaper than new consumption bundle x h (1) and by revealed preference is strictly preferred by the new consumption bundle. If government tax revenue in a such scheme is non-negative, it implies that original consumption bundle x h (0) is feasible measured by new prices when consumer has income y h (1) and by revealed preference new consumption bundle x h (1) is at least as good as old consumption bundle x h (0) . But this is just usual revealed preference approach applied in one step only. Using Ju (2002) multi-step tax adjustments, it is impossible to return consumer back to the state 0 if he is now in the state 1 because market prices and income are fixed on the levels p (1) and y h (1) respectively and consumer can not pay several times different sets of taxes if he is only in one state 1.

15 If he is in different states, then a sum of tax incomes collected in different (time) states does not have economic sense in general. Only using one direct tax adjustment we can return him to the original state 0. This is argument that was used in Dixit and Norman (1986). As a result, Ju (2002) arguments are incorrect, see further propositions. However, the specified forward induction technique has sense for (piecewise) monotonous utility adjustment paths. Let assume, that on each step m the sum of tax revenue is positive (non-negative):
R h (t m ) > 0 ( R h (t m ) 0 ). Then by revealed preference, consumer h is strictly better off (at least as

well off) in state m than in state m-1 from utility point of view: u h (t m ) > u h (t m1 ) ( u h (t m ) u h (t m1 ) ). Summing up all M steps, we receive then, that the sum of tax revenue over all steps TR h is positive (non-negative) and consumer is better off (at least as well off as) in state 1 than in state 0. As a result, when we go to the limit, there can be adjustment paths, along which consumer utility is strictly increasing (non-declining) and the change in the sum of Marshallian surplus and consumer income is positive (non-negative). The same results we can receive applying the Strong Axiom of Revealed Preference. A variant of the Axiom (see Jehle and Reny 1995) states that, for any states 0 and 1, if, for every monotonous chain with M steps such that on each step m state s(tm ) is strictly directly revealed preferred to state s(tm1 ) by consumer h (or, equivalently, state s (t M ) is strictly indirectly reveled preferred to initial state s (t1 ) by consumer h) then it is impossible to find a monotonous chain along which consumer h strictly directly or indirectly revealed prefers state s (t1 ) to state s (t M ) . However, if on the step m state s(tm ) is strictly directly revealed preferred to state s(tm1 ) , this implies that tax income from consumer h is positive: p (tm ) x h (tm ) > p(tm ) x h (tm 1 ) R h (tm ) > 0 . Then, we see that along such monotonous chain a sum of tax revenues is positive and we establish equivalence between strong axiom and reconstructed multi-step tax adjustment scheme: consumer surplus along subset of monotonous and piecewise monotonous paths is continuous analogue of the Strong Axiom. Let consider formal justification of the result for the monotonous directed adjustment paths, along which consumer utility changes monotonously. From Antonelli (1886, 1971) equation (Roys identity) it follows that i xih = v hi ( p, y h ) / v hh ( p, y h ) , where v h () is indirect utility function of p y consumer h and subscripts denote respective partial derivatives. Taking derivative of indirect utility function v h ( p (t ), y h (t )) with respect to t, we have:
h h v h ( p(t ), y ) N v ( p(t ), y (t )) pi (t ) v h ( p(t ), y h (t )) y h (t ) = i =1 + t pi (t ) t y h (t ) t

16
N v p ( p ( t ), y ( t )) pi ( t ) e h ( p (t ), u h ( t )) v h ( p (t ), y h (t )) y h ( t ) = i =1 hi + u h (t ) t v y h ( p(t ), y h (t ) t t h h

from which, applying Antonelli equation, we receive:


N e h ( p(t ), u h ( x(t ))) u h ( x(t )) y h (t ) p (t ) = i =1 xih (t ) i h u ( x(t )) t t t

where e h (( p(t ), u h (t )) / u h ( x(t )) is reversal of Largange multiplier marginal costs (expenditure) of utility. As the above expression holds for any t, we can integrate it along time path [0,1] :
N p (t ) e h ( p(t ), u h ( x(t ))) u h ( x(t )) dt = y h (1) y h (0) i =1 xih ( p(t ), y h (t )) i dt u h ( x(t )) t t 0 0 1 1

(6)

The right part of equation (6) is the change in the sum of consumer income and Marshallian surplus. The left part of equation is integral of marginal costs of utility over time adjustment path. The sum of the change in consumer income and Marshallian surplus is positive (non-negative) when and only when the integral of marginal costs of utility: de h ( p(t ), u h ( x(t ))) h du ( x(t )) du h ( x(t )) uh ( 0 ) is positive (non-negative). Let assume that consumer utility increased (non-declined): u h (1) > u h (0) ( u h (1) u h (0) ). It is trivial that e h ( p(t ), u h (t )) > 0 and that marginal utility of income and marginal costs of utility are positive (what follows from strict monotonicity of consumer preferences and increasing property of direct utilities): e h (( p(t ), u h (t )) / u h (t ) > 0 . We argue then that we can every time find monotonous directed adjustment path along which the consumer utility is monotonously increasing or non-declining. As a result, along such adjustment path, Marshallian surplus measure is positive (non-negative) when and only when consumer utility in state 1 is larger (non-lower) than in state 0: CS h (0,1) > 0 and path is monotonous u h (1) > u h (0); CS h (0,1) < 0 and path is monotonous u h (1) < u h (0); CS h (0,1) = 0 and path is monotonous u h (1) = u h (0). On the other hand, it is obvious from (7) that if marginal utility of income is constant along adjustment path, change in the sum of consumer surplus and income is a relevant measure of consumer utility. Exactly, this is a case when consumer preferences are quasilinear with respect to some good. If consumer preferences are homothetic and marginal utility of income is fixed along path, then change in the consumer utility is equal to the product of the marginal utility of income and change in the consumer income. This is because marginal utility of income for homothetic preferences is equal to average utility of income. For piecewise monotonous paths conclusion is the
u h (1)

(7)

17 same and is obtained by the obvious combination of statements for monotonous paths (or segments of path). Summarizing all the above, we have
Proposition 1. Let assume that functions x h ( p(t ), y h (t )) ,

y h (t )

and p h (t )

are C 2

on

path : [ 0,1] Sl . The change in the sum of consumer income and individual Marshallian surplus (1) over path : [ 0,1] Sl generating (piecewise) monotonous utility adjustment path or adjustment path with constant marginal utility of income is positive (non-negative) if and only if consumer is strictly better off (at least as well off) in state 1 compare with state 0. The proposition states that the sum of consumer income and net Marshallian surplus is correct Marshallian money metric indirect utility measure only for (piecewise) monotonous utility adjustment paths or adjustment paths with constant marginal utility of income. Generally the value of consumer surplus depends on the way of integration, as it was proposed by numerous authors, see ex. Burns (1976). To understand more the difficulty arising because of path dependence problem, we need to consider important proposition that is respective modification of the more general statement that could be found in any advanced calculus textbook (see ex. Nikolsky (1983), p. 79, or Apostol (1957), pp. 276-93, and also compare Chipman and Moore (1976)):
Proposition 2. If there is no restriction in the budget space, then it is never possible that CS will be

path-independent. Let consider region G that belong to some space E. Then the following statements are equivalent: 1) There exists vector-valued function v h ( p, y h ) such that its partial derivatives are continuous and satisfy on G: v h ( p, y h ) = ( x h ,1) and there is a restriction in the budget space. 2) Integral over any closed (returned to the initial point 0) continuous piece-wise smooth adjustment path h (t ) = h ( p(t ), y h (t )) that belong to G is equal to zero:
xih ( p (t ), y h (t ))
i =1 0 N 0

pi (t ) dt = 0. t

3) For each initial fixed point A0 = ( p(0), y h ( 0)) the sum of the change in Marshallian surplus and consumer income is path-independent and equal to the change in potential function v h ( p, y h ) :
y (1) y (0) xih ( p (t ), y h (t ))
h h i =1 0 N 1

pi (t ) dt = v h ( p (1), y h (1)) v h ( p (0), y h (0)). t

If there is a numeraire which price is normalized to unity, then consumer preferences are quasilinear with respect to this numeraire and potential function is consumer h indirect utility function.

18 Proof: we do not show the equivalence of points 1-3, as this is just a special version of respective theorems from the theory of line integrals or theory of curve integrals of the second type (see ex. Nikolsky (1983), p. 79). We concentrate on the proof of the statement that the potential function v h ( p, y h ) is consumer h indirect utility function in this case and that consumer preferences are quasilinear with respect to numeraire. From the Proposition 1 it follows that consumer surplus represents change in consumer utility along subspace of monotonous paths connecting 0 and 1: CS h (0,1) > 0 and path is monotonous u h (1) > u h (0); CS h (0,1) < 0 and path is monotonous u h (1) < u h (0); CS h (0,1) = 0 and path is monotonous u h (1) = u h (0). As in the point 3 of current proposition CS is path-independent, it follows that its value along any path connecting 0 and 1 is the same and because of that should represent change in consumer utility: CS h (0,1) > 0 and CS is path-independent u h (1) > u h (0); CS h (0,1) < 0 and CS is path-independent u h (1) < u h (0); CS h (0,1) = 0 and CS is path-independent u h (1) = u h (0). This implies from the point 3 that: v h ( p(1), y h (1)) v h ( p(0), y h (0)) > 0 u h (1) > u h (0); v h ( p(1), y h (1)) v h ( p(0), y h (0)) < 0 u h (1) < u h (0); v h ( p(1), y h (1)) v h ( p(0), y h (0)) = 0 u h (1) = u h (0). This proves that potential function v h ( p(t ), y h (t )) is consumer h indirect utility function for some direct utility function that represents consumer preference relation. From point 1 of proposition we have: v h ( p, y h ) / y h = 1 : marginal utility of income is fixed and equal to unity along any path connecting 0 and 1. From Samuelson (1942) and Chipman and Moore (1976) we know that this condition can hold only when some restriction in the budget space is introduced. Say then, that price of some good k is set to unity: this good is numeraire by assumption. From the first order condition u h ( x h (t )) = h p(t ) then it follows that u h (t ) / xkh (t ) = 1 along any path and in each point of any paths, if price of numeraire is unity. This proves that consumer h preferences should be quasilinear with respect to good k and utility function should have
h form u h = z ( x k ) + xkh .

Also,

looking

to

point

of

proposition,

we

see

that

(v h ( p, y h ) / pi ) /(v h ( p, y h ) / y h ) = v h ( p, y h ) / pi = xih what implies that potential function sat-

19 isfies Antonelli equation (Roys identity) what again support the fact that it is indirect consumer h utility function. Q.E.D. We see that the potential function v h () is indirect utility function for consumer h and with specified restriction in the budget space the CS integral is path-independent when and only when consumer preferences are quasilinear with respect to some specified commodity. This is a very restrictive case: demand for any good except numeraire should be independent (after some initial threshold) from income changes. To confirm this idea, recall that indirect utility function in this case is twice differentiable on its domain, that is why we have from symmetricity condition and from Antonelli equation: xih ( p, y h ) 2 v h ( p, y h ) 1 2 v h ( p, y h ) i = = = =0 pi pi y h y h y h pi that again support the fact that consumer preferences should be quasilinear. As a result, we confirm general results of Chipman and Moore (1976). It follows from the proposition, that in order to be correct measure of individual utility consumer surplus should be path-independent because, as we return to the initial point A0 along closed adjustment path, the value of the integral should be equal to zero. Exactly, it is impossible that consumer utility or welfare increased or declined in the state 0 compare with the same state 0. However, for closed monotonous utility adjustment paths change in the consumer surplus is identically zero: these are paths along which prices and income do not change and CS h / t = 0 for

t [ 0,1] . To prove, assume that some segment of interval [ 0,1] exists along which CS and utility
are changing, say increasing. Then, in order for the path to be monotonous, along full interval [ 0,1] utility and CS should increase with CS h / t > 0 what implies that utility in state 1 is higher than utility in state 0. But as the path is closed, utility in state 0 should be the same, as in state 1 contradiction. So, we can not find a segment in [ 0,1] along which CS or utility are changing, from this we prove our statement. Notice that along non-monotonous closed adjustment paths the value of consumer surplus generally is not zero and this means that consumer surplus is not utility measure along any adjustment path for any type of consumer preferences. Notice also that piecewise monotonous closed path does not exist. To prove, recall that state interval [ 0,1] should consist in this case from several segments, along some of them utility does not change and along other segments it increases, for example. Then utility in the state 1 will be higher than in state 0, as CS measures correctly change in utility along piecewise monotonous path. But as the path is closed, utility in state 0 is the same, as in state 1 contradiction. Next figure represents the taxonomy of adjustment paths.

20

Full Space of Paths


A Subset of (Piecewise) Monotonous Adjustment paths

A Subset of Non-Monotonous Adjustment paths

A Subset of Closed Adjustment Paths Closed Monotonous Adjustment Paths: CS = 0 Closed NonMonotonous Adjustment Paths Fig. 1 Another usual criticism towards Marshallian surplus measure is that generally marginal utility of income is not constant and even can not be constant (what was shown by Samuelson (1942) but has only one exception quasilinear or homothetic preferences) and from Antonelli equations (or Roys identity) it follows that generally Marshallian surplus can not represent change in consumer utility. Our answer is that Marshallian surplus is money metric utility measure only for monotonous adjustment paths, along which marginal utility of income is changing but has positive value and it is indirect utility function for paths with constant marginal utility of income, for example, for quasilinear preferences for any adjustment paths. We provide below examples to clarify the welfare meaning of Marshallian welfare measure when marginal utility of income is changing along monotonous adjustment path. Example 1. Let assume that consumer has Cobb-Douglas utility function u = xii with
i =1 N

i =1

i = 1 . Let then assume that prices and income are k times greater in state 1 compare with state

0 and change in time interval [0,1] according to the law:


y ( t ) = y (0)(1 + kt t ) p (t ) = p ( 0)(1 + kt t )

Applying (4) we receive the change in Marshallian utility measure:

w(0,1) = y (1) y (0) i =1 i


N 0

y (0)(1 + kt t ) dpi (t ) dt pi (0)(1 + kt t ) dt

= ky (0) y (0) i =1 i
N 0

y ( 0) (k 1) pi (0)dt = 0 pi (0)

21 We see that Marshallian utility measure is real welfare measure like any other (indirect) utility function. Let calculate Lagrange multiplier for consumer maximization problem marginal utility of income:

dv( p(t ), y (t )) = = dy (t )

i
i N

=
i
i

p
i =1

(t )

(1 + kt t ) pii (0)
i =1

Marginal utility of income is generally changing along time adjustment path, but this fact does not eliminate here welfare meaning of Marshallian utility measure.
Example 2. Assume that consumer again has Cobb-Douglas utility function: u = x1 x 1 . Let con2

sumer income and prices change in state interval [0,1] according to the law:
y (t ) = y (t + 1)

p1 (t ) = p1 (t + 0.5)

p2 (t ) = p2 (t + 2)
Using (3), we calculate the change in Marshallian measure:
1

w(0,1) = y (1) y (0)


0 1

(1 )(t + 1) y (t + 1) y p1dt p2 dt p1 (t + 0.5) p 2 ( t + 2) 0


1

0.5 1 = y y 1 + dt (1 ) y 1 t + 2 dt t + 0.5 0 0

= y ln( 21 31.5 1 )

(A1)

Let assume now that = 0.5 . Then (A1) will look as w(0,1) = y ln(2 0.5 30.25 ) < 0 . Let now check the change in consumer utility function:
0 u (1) 0.5 y 2 0.50.5 p10.5 2 0.5 p2 .5 2 = = <1 0.5 0.5 0.5 0.5 u (0) 1.5 p1 3 p2 0. 5 y 4.50.5

We see that for any fixed price vector p and income y Marshallian measure gives correct ranking of consumer well-being. It is easy to check that the path is monotonous. Again we can calculate marginal utility of income to verify that it changes along adjustment path. Again marginal utility of income depends here on prices such that Chipman and Moore (1976, pp. 81-85) argument for homothetic preferences is not applied here. Even despite changing marginal utility of income and path dependence problem the sum of Marshallian surplus and consumer income is a correct individual welfare measure!

22

4. Marshallian Money Metric Social Welfare Measure


If individual consumer surplus is not in general correct utility measure, then what can we say about a sum of all consumers net surpluses and incomes? Ju (2002) proposes that Marshallian social welfare measure CS (0,1) is utilitarian social welfare indicator and derive a statement: if state 1 Pareto dominates state 0, change in the sum of consumers incomes and Marshallian net surpluses should be non-negative, and if change in the sum of consumers incomes and Marshallian net surpluses is positive, this is sufficient for potential Paretoimprovement. We will argue here that it is generally not true. Only for monotonous adjustment paths for the efficient social welfare function, i.e. the paths, along which specified efficient social welfare function that supports a sequence of economic equilibria changes monotonously and for the paths with constant social marginal utility of total income, aggregate Marshallian surplus measure
CS (0,1) represents change in efficient social welfare (function), but even in this case it is not gen-

erally sufficient for potential Pareto improvement in Kaldor sense. If adjustment path is not monotonous, or ratios of consumers marginal utilities of income are changing along adjustment path then such Marshallian measure is not correct efficient social welfare indicator. It can be correct efficient social welfare indicator along any adjustment path with unitary price of numeraire if equilibrium representative consumer preferences are quasilinear with respect to some good. To make further analysis, we need some definitions (see Jerison 1994, Mas-Colell et al. 1995). Definition. Equilibrium representative consumer is a preference relation that rationalizes or repre-

sents only given price equilibrium with transfers. Its utility function is given by:
U (X ) =
x = ( x ,... x ) 0

max 1 H

a hu h ( x h ) s.t. i X i = xih
h =1 h =1

(8)

where a h are parameters of efficient social welfare function that supports given economic equilibrium. We will show later, that such representative consumer every time represents given economic equilibrium, generically it does not rationalize aggregate demand function such as normative representative consumer doing. First-order conditions for the problem (8) look as follows (consider interior solutions):

ah

u h ( x h ) u k ( x k ) = i = a k i, k , h xih xik

(9)

Here i are respective Lagrange multipliers for the problem (8).

23 Definition. Positive representative consumer for social welfare function W ( u ) is a preference rela-

tion

rationalizing aggregate demand X ( p, y ) := h =1 x h ( p, y h ) for any equilibrium priceH

income pairs.
If there is no restriction in the budget space, such representative consumer exists when and only when each consumer preferences are of Gorman type. A typical restriction in the budget space is an introduction of a wealth distribution rule. In this case demand looks like this:

X ( p, Y ) := h =1 x h ( p, y h ( p, a, Y )) where price vector p in general equilibrium is a function of


H

economy fundamentals and total nominal income Y and y h ( p, a, Y ) is continuous and homogeneous of degree one wealth distribution rule (see Mas-Colell et. al., 1995) solving social welfare maximization problem:
y = ( y ,... y ) 0

max 1 H

a v
h =1

h h

( p, y h ) s.t.

H h =1

yh = Y .

Notice that wealth distribution rule y h ( p, a, Y ) depends on (fixed) parameters a h of social welfare function W ( u ) (see further discussion) and thats why aggregate demand correspondence and preferences of representative consumer in general depends on the choice of social welfare function

W ( u ) . Let assume now that in state 0 we have wealth distribution rule y 0 = y 0 ( p 0 , a 0 , Y ) solving

maximization

of
H

W 0 (v( p 0 , y )) .

As

result

we

receive

aggregate

demand
0

X 0 ( p 0 , a 0 , Y ) := h=1 x 0 h ( p 0 , y 0 h ( p 0 , a 0 , Y )) that can be rationalized (by assumption) by

By

construction, this positive representative consumer is normative for social welfare function W 0 (u ) , ~ that is, his indirect utility function V 0 ( p 0 , Y ) is a value function for any social welfare maximization problem
y = ( y ,... y ) 0

max 1 H

W 0 (v( p 0 , y )) s.t.h =1 y h = Y that supports equilibria in a given economy.


H

At the same time it is value function for the normative representative consumer utility maximization problem max U 0 ( X 0 , Y ) s.t. p 0 X 0 = Y . 0
X 0

Notice that if normative representative consumer exists in a given economy, it coincides with equilibrium representative consumer (but not the opposite). To proceed further, let consider a sequence of equilibria that are supported by the specified social welfare function W ( u ) along state interval [0,1] . The respective equilibrium budget space
B (W ) N H is a set of all equilibrium price-incomes pairs for the full set of equilibria that are + +

supported by this social welfare function. The specified social welfare function W ( u ) supports or represents given economic equilibrium if solution for the social welfare maximization problem is identical to the general equilibrium values of prices, incomes and supply-demand decisions. Such

24 social welfare function was called efficient by Ju (2002). Any Walrasian general equilibrium can be supported by efficient social welfare function, as propositions in Mas-Colell (1985), Mas-Colell et al. (1995, p. 767), Varian (1992) shows. The following proposition gives general form of the efficient social welfare function in the static case, the same can be applied in dynamic setting (compare with propositions in Varian 1992, Mas-Colell et al. 1995).
Proposition 3. Let consider a production economy with neoclassical properties of utility and pro-

duction functions and consider a space of efficient social welfare functions such that i) it is a class of possible social welfare functions that supports Walrasian equilibrium given economy fundamentals F and ii) the solution to social welfare maximization problem is exactly equivalent to Walrasian equilibrium with transfers. Then such space can be normalized to the efficient social welfare function:
W (u ) = a h u h ( x h )
h =1 H

= ( p, Y )

uh (xh ) h h h =1 ( p , y )
H

(10)

where a h = ( p, Y ) / h ( p, y h ) , ( p , Y ) is marginal social utility of total national income


V ( p , Y ) / Y for respective indirect social welfare function and h ( p, y h ) is marginal utility of

income for consumer h utility maximization problem. Proof: Let consider the following social welfare maximization problem for some social welfare function W(u) with fixed parameters:
x = ( x1 ,... x H ),l = ( l1 ,...l H ), r = ( r1 ,...r H ) 0 N

max

W ( u1 ( x1 , l 1 , r1 ),...u H ( x H , l H , r H ) )

(11)

s.t. T = lih + r h h ,
i =1

x
h =1

h i

= f i (li ) i

where f i (li ) - production function for the i -s product, lih - labor of agent h spent in the production of i -s product, r h - leisure of agent h , T is time endowment. The first order conditions for the problem (11) are equivalent to the first order conditions of Walrasian equilibrium and under standard convexity assumptions about utility functions and production sets we have second fundamental welfare theorem applied here. It easy to show that from the first order condition it follows that: dW m m du l = ui = dW uil l du m

(12)

25
l , m = 1...H , i = 1... N

We have proved that a ratio of marginal social values of consumers utilities is equal to the reciprocal ratio of consumers marginal utilities of income. To finish the proof, we need to recall that in any Pareto optimal allocation national income is optimally distributed, see Jerison (1994). Then we can consider a social welfare maximization problem that gives optimal income distribution (for a given equilibrium) and wealth distribution rule for a set of consumers, such problem should be equivalent to the problem (11):
y = ( y1 ,... y H ) 0 H

max

W (v( p, y ))

s.t. h =1 y h = Y

(13)

First order condition for this problem implies:


W (u ) h = u h

h
what is consistent with (12) and gives a general form of efficient social welfare function (10). Q.E.D. Now we can state important proposition relating two main concepts.
Proposition 4. Let utility possibility set U is convex. Then, equilibrium representative consumer

defined by (8) represents any given Walrasian equilibrium (or price equilibrium with transfers). Its marginal utility of income is identically equal to the marginal social utility of national income . Proof: Let equilibrium representative consumer exists. Compare first order conditions (9) and (12) to convince yourself that they are identical: this consumer represents the same solution as general equilibrium in a given economy. Consider then first order condition for this consumer utility maximization problem:
U ( X ) = pi X i

(14)

where is representative consumer marginal utility of income. Applying Envelope Theorem to (8), we receive:
pi = i

(15)

Then, using (8), (9) and (10), we have:

=
Q.E.D.

U ( X ) 1 i a h u h ( x h ) = = = ah h = h X i pi pi pi xi

We have just shown that if a sequence of equilibria is supported by the specified efficient social welfare function then equilibrium representative consumer exists such that his preferences are

26 fixed along adjustment path, his indirect utility function V ( p, Y ) is a value function for the social welfare maximization problem (13) for any price-incomes pairs in equilibrium budget space

B(W ) N H and for which maximized social welfare function W ( u ) can be represented by + + (10). The above propositions can shed light on measurability of the change in efficient social welfare. Exactly, the efficient social welfare function is fixed along adjustment path and efficient social welfare is measurable along adjustment path if and only if ratios (parameters of utilitarian social welfare function):

= ah

are fixed along adjustment path. This implies that efficient social welfare is measurable along path if either both social marginal utility of total income and consumers marginal utilities of income are fixed along path or they are changing but ratios of marginal utilities of income for different consumers are the same along adjustment path. These conditions can be restrictive indeed, and they of course specify the restriction on equilibrium budget space B (W ) 20. Let consider, for example, homothetic preferences that are represented by linear homogeneous utility functions. In this case marginal utility of income is equal to the average utility of income. If all marginal utilities are fixed along path, then change in the efficient social welfare is equal to the product of marginal social utility of total income and change in the total nominal income. As we can anytime normalize marginal social utility of total income to unity in this case, the change in efficient social welfare can be normalized to the change in the total nominal income. This is not strange: Lagrange multipliers play role of consumers price indexes for homothetic preferences, so when they are fixed, social rate of inflation is zero and we can use total nominal income as a social welfare measure. If marginal social utility of total income is changing along adjustment path then from (10) efficient social welfare can be represented as

W = Y
Then marginal social utility of total income is equal to the average social utility of the total income in any given state. As a result, we can interpret marginal social utility of total income as correct GDP deflator in homothetic case, or inverse of it as a correct aggregate price index. Summarizing, we have

20

This is why generally Antonelly equation or Roys identity does not hold for aggregate demand for any price-income pairs and that is why normative representative consumer may not exist for the specified efficient social welfare function for any price-income pairs, that is, for the price-income pairs outside equilibrium budget space. Antonelly equation should not hold for the price-incomes even from equilibrium budget space.

27
Proposition 5. If consumers preferences are homothetic, marginal social utility of total income is

constant along adjustment path and efficient social welfare is measurable along adjustment path, then change in efficient social welfare is equal to the change in total nominal income. Compare this statement with Chipman and Moore (1973) opening: they found that if consumer preferences are homothetic and identical then change in the social welfare as a potential Pareto improvement (or deterioration) can be measured by the change in the total real income measured by the new or old prices. As equilibrium aggregate demand (defined for price-incomes from equilibrium budget space) is every time generated by equilibrium representative consumer utility maximization problem for the specified social welfare function, then for this equilibrium budget space we can write down firstorder conditions for the equilibrium representative consumer utility maximization problem. Because marginal social utility of total income is equal to the average social utility of total income in this case, equilibrium representative consumer preferences should be homothetic and his direct utility function U ( X ) should be linear homogeneous21. Just multiply both sides of first order conditions: U ( X ) / X i = pi by aggregate demand X i and sum them up. Then linear homogeneity goes from the Euler Theorem. Let then discuss the relation between efficient social welfare function and aggregate Marshallian surplus. Let consider the change in efficient social welfare function:
W (0,1) = W (1) W (0)

=
h =1 0

H 1

H W (u ) u h u h W (t ) dt = h dt = dt. h u t t t h =1 0 0

Then, applying (6) and definitions of CS, we can receive absolutely analogous to (6) condition for the equilibrium representative consumer case:
H H H N p (t ) 1 W (t ) dt = y h (1) y h (0) xih i dt t t h =1 h =1 h =1 i =1 0 0

= Y (1) Y (0) i =1 X i (t )
N

pi (t ) dt t

(16)

As a result, we have proposition that is analogous to the proposition 1.


Proposition 6. Let assume that functions X ( p ( t ), Y (t )) , Y (t ) and p (t ) is piece-wise differentiable

on adjustment path : [ 0,1] Sl . The change in the sum of total nominal income and aggregate

21

Notice that Chipman and Moore (1980b) required fixed total income distribution in order for normative representative consumer preferences to be homothetic if individual consumers preferences are homothetic when efficient social welfare function that rationalizes a sequence of equilibria is changing along adjustment path. In our case efficient social welfare function is fixed along adjustment path.

28 Marshallian surplus over path : [ 0,1] Sl is indirect efficient social welfare function if at least one of the following conditions is satisfied: i) adjustment path is monotonous: efficient social welfare function changes monotonously along path, marginal social utility of total income is positive and ratios of consumers marginal utilities of incomes are fixed along adjustment path; ii) consumers' marginal utilities of income and marginal social utility of total income are constant along adjustment path. Finally, we want to state and prove the following important proposition that arising as a respective modification of proposition 2 for the equilibrium representative consumer case.
Proposition 7. Let consider region G that belongs to some space E. If there is no restriction in the

budget space then it is never possible that CS will be path-independent. The following statements are equivalent (for the existing restriction in the budget space): 1) There exists vector-valued function V ( p, y ) such that its partial derivatives are continuous and satisfy on G: V ( p, y ) = ( h =1 xih ,1) .
H

2) Integral over any closed (returned to the initial state 0) continuous piece-wise smooth adjustment path (t ) = ( p (t ), y (t )) that belong to G is equal to zero:
xih ( p (t ), y h (t ))
i =1 h =1 0 N H 0

pi (t ) dt = 0. t

3) For each initial fixed point A0 = ( p(0), y (0)) Marshallian surpluses is path-independent and equal to the change in potential function V ( p, y ) :

y
h =1

(1) y h (0) xih ( p (t ), y h (t ))


h =1 i =1 h =1 0 N 1

H 1

pi (t ) dt t

= Y (1) Y (0) X i (t )
i =1 0

pi (t ) dt t
1

= CS h (0,1) =
h =1

H N x h ( p (t ), y h (t )) 1 v h ( p (t ), y h (t )) dt = pi (t ) i dt h t t h =1 0 (t ) h =1 i =1 0

H 1

= V ( p (1), y (1)) V ( p (0), y (0)) If price of numeraire is unity, then each consumer preferences are quasilinear with respect to the same numeraire and potential function V ( p, y ) is Bergson-Samuelson indirect social welfare function defined as:
h h V ( p, y ) := h =1 v h ( p, y h ) = h =1 (v k ( p ) + xk ( y h )) = h =1 (v h ( p ) + y h ) = h =1 v h ( p ) + Y , where k H H H H

is numeraire (all functions are defined for interior optima).

29 Aggregating and taking V ( p, Y ) := V ( p, y) : Y = h=1 y h , again we have the following equivaH

lence: 4) There exists vector-valued function V ( p, Y ) such that its partial derivatives are continuous and satisfy on G: V ( p , Y ) = ( X ,1) . 5) Integral over any closed (returned to the initial state 0) continuous piece-wise smooth adjustment path (t ) = ( p (t ), Y (t )) that belong to G is equal to zero:
X i ( p (t ), Y (t ))
i =1 0 N 0

pi (t ) dt = 0. t

6) For each initial fixed point A0 = ( p (0), Y (0)) the sum of Marshallian surpluses and consumers incomes is path-independent and equal to the change in potential function V ( p , Y ) :
Y (1) Y (0) X i ( p (t ), Y (t ))
i =1 0 N 1

pi (t ) dt = V ( p (1), y (1)) V ( p (0), y (0)). t

If price of the numeraire is fixed to unity, this potential function is normative representative consumer indirect utility function. His direct utility function is quasilinear with respect to the numeraire. Proof: This proposition is again a corollary of the famous theorems from the theory of the line integrals or the theory of the curve integrals of the second type (Russian version), see proof of the proposition 2 and also Nikolsky (1983), p. 79, or Apostol (1957), pp. 276-93, compare with Blackorby and Donaldson (1999). The fact that each consumer preferences are quasilinear with respect to numeraire is proved in the same fashion as in proposition 2. From point 1 we have that V ( p, y ) / y h = 1 h , this means that income redistribution does not change level of this function. By comparing points 3), 4) and 6), we see that potential function in 6) should have form V ( p, y ) = h =1 v h ( p ) + Y and by the fact that
H

V ( p, y ) / y h = 1 we see that each consumer preferences should be quasilinear with respect to the same numeraire. If CS is path-independent and equal to the change in potential function, then obviously normative representative consumer (weak social preference relation R) exists that is defined as follows:
s , s S

s Rs V ( s ) V ( s )

This consumer, by construction, rationalizes aggregate demand not only for equilibrium prices, but for disequilibrium prices as well (as social states may be disequilibria, not only equilibria). It is clear then (and also by construction) that potential function V ( p, Y ) is indirect utility function for this normative representative consumer. To convince yourself, consider point 4 in the current

30 proposition: (V ( p, Y ) / pi ) /(V ( p, Y ) / Y ) = V ( p, Y ) / pi = X i , so Antonelli equation (Roys identity) is satisfied for this potential function. Then from again point 1 and from (16) we have:
W (0,1) = CS (0,1)

as

= V ( p, Y ) / Y = 1 .

And,

comparing

with

3)

we

have:

CS (0,1) = V (0,1) = V (0,1) what again supports this fact. So, this path-independent social CS is identically equal here to the change in indirect Bergson-Samuelson social welfare function that supports any sequence of equilibria along any path that is connecting any two given social states and along which parameters of this efficient social welfare function are fixed. This normative representative consumer preferences are quasilinear with respect to numeraire (it follows from the first order condition for this consumer, consider interior solutions), as social marginal utility of total income V ( p , Y ) / Y is equal to unity and price of numeraire is fixed to unity, see also proof of the proposition 2. From definitions of the normative representative consumer and equilibrium representative consumer it follows that our unique R is also equilibrium representative consumer and that potential function V ( p, Y ) is also indirect efficient social welfare function that supports any sequences of equilibria. Notice that from (9) and (15), combining with the fact that
= V ( p, Y ) / Y = 1 it follows that (parameters of efficient social welfare functions) a h = 1 and

efficient social welfare function looks like W = h =1 u h ( x h ) (utility possibility curves are parallel
H

lines with 450 angle for interior consumers optima). Q.E.D. The Ju (2002) case is just a special one with unitary marginal social utility of income. As we just have seen, this implies quasilinear preferences if we apply Marshallian surplus for any adjustment path. That is why we see inconsistency in Ju results concerning optimal income distribution case and in his numerical example, that will be shown as a non relevant in the next section. Our analysis can be easy extended to dynamic general equilibrium case. We know that dynamic economy is just Cartesian product of static economies. Exactly, any dynamic competitive general equilibrium can be supported by efficient social welfare function of the type W = h =1 a h u h ( x h )
H

where u h are intertemporal utility functions (see Mas-Colell, Whinston and Green 1995). Then change in efficient social welfare W is measured by social consumer surplus along monotonous path if parameters of the function W are not changing along the path. The next important topic we want to investigate is relation between Marshallian aggregate surplus and standard revealed preference approach.

31

5. Impossibility of Applying Standard Aggregated Revealed Preference Approach for a Welfare Evaluation of Economic Reforms
In Ohyama (1972), Ju and Krishna (1998) and in Ju (2002) a standard aggregated revealed preference approach is used for the social welfare evaluation of economic reforms. In the former papers, it was used for the evaluation of the trade reform, and in the latter paper for the evaluation of income redistribution. In Dixit and Norman (1986) revealed preference argument was used for the proof of potential Pareto superiority of trade liberalization. The idea behind this old aggregated standard revealed approach is simple: if old aggregated consumption bundle is feasible when representative consumer chooses new aggregated consumption bundle, then it was concluded that we have sufficient condition for potential Pareto-improvement. We will argue in this section, that such logic is inconsistent with the nature of the problems involved and that standard aggregated revealed preference approach can not be used for the evaluation of the social welfare change if we have structural changes such as economic reform. The original criticism towards such revealed preference argument (which is also widely named as National Income Test) had given by Samuelson (1950). Later it was extensively developed by Chipman and Moore (1973) and (1980b). In the former paper, they had shown that (if there is no restrictions in the budget space) a change in the real national income represents potential Pareto improvement if and only if consumers' preferences are identical and homothetic. In the latter paper they argued that if income distribution is fixed, then a change in the real national income represents potential Pareto improvement again if and only if consumers preferences are identical and homothetic a very restrictive case. In the recent paper, Montesano (2007) claims that rise in real national income is neither sufficient nor necessary condition for potential Pareto improvement in the abstract production economy. These authors did not fix efficient social welfare function that rationalizes a sequence of equilibria, as we are doing in this paper. If we fix such social welfare function, the revealed preference principle still can be used, see further discussion. To support our point of view, let consider the numerical example in Ju (2002, p. 24-29). The economy consists on two consumers with Cobb-Douglas utility functions and two supply functions for two goods that are exogenously supplied, consumers incomes are fixed, and total income is normalized to unity. Economic reform implies here optimal income redistribution. Author argues that optimal income redistribution in any Walrasian equilibrium can represent potential Paretoimprovement (in his example change in the aggregate Marshallian surplus and total income is positive for the analyzed income redistribution). We argue that it is not true: any competitive equilibrium with transfers at state 0 is Pareto optimal. If we go to the state 1 using lump sum income redis-

32 tribution, then the state 1 would be competitive equilibrium with transfers, that is, also Pareto optimal. Then, if there is a potential Pareto-improvement, then there should exist another competitive equilibrium with transfers that is Pareto-superior to the state 0. But this implies that state 0 is not optimal a contradiction. On the other hand, the above discussions have clearly shown that aggregate Marshallian surplus can be used only for quasilinear preferences if we do not specify relevant adjustment path, so it can not be applied in Ju case. It is absolutely clear, that in Ju example consumers marginal utilities of income are not constant as commodities prices are changed, what implies that parameters of efficient social welfare function are also changed. In case of two-goods, two-consumers homothetic environments with unitary marginal social utility of total income, social welfare function is fixed along adjustment path when and only when commodities prices are fixed. As a result, change in the efficient social welfare is un-measurable in considered example. On the page 29 author tests his results using revealed preference approach to the representative consumer, that is, using aggregate consumption of this normative representative consumer. Ju (2002) shows that for the representative consumer original aggregated consumption bundle is feasible, that is, lies inside new aggregated budget set and it looks like utility of (equilibrium) representative consumer (social welfare) increased as a result of income redistribution. But it is well known that equilibrium representative consumer (or positive representative consumer) cannot be normative representative consumer for every social welfare function. Of course, in the special case of quasilinear preferences, normative consumer exists for any social welfare function and change of his utility represents the change in social welfare for any social welfare function, as in quasilinear case preferences of representative consumer do not depend on the choice of social welfare function. But in Ju case preferences are not quasilinear. Then, Pareto-improvement may imply growth of social welfare function (if it is correctly chosen), but increase of social welfare function, in turn, does not imply neither potential nor actual Pareto-improvement in general. Let us consider the problem in deeper sense. Or, in other words, preferences of equilibrium representative consumer had changed. Exactly the same situation arises in numerical example in Ju (2002). We reproduce the following data on prices and aggregate demand for the states 0 and 1 from Ju (2002):
0 ( p10 , p 2 ) = (3.1623;1.0541) ; 0 ( X 10 , X 2 ) = (0.2846;0.09487) ; 1 ( p1 , p1 ) = (1.4142;1.4142) ; 2 1 1 ( X 1 , X 2 ) = (0.07071;0.6364) .

33 Let us prove our hypothesis that equilibrium representative consumer preferences were changed. For this purpose we can apply standard revealed preference approach for the move from state 1 to the state 0:
1 0 0 1 p 0 ( X 0 X 1 ) = p10 ( X 10 X 1 ) + p2 ( X 2 X 2 ) = 0.10556 > 0

We received interesting result: new aggregate consumption bundle X 1 was feasible when equilibrium representative consumer had chosen old bundle X 0 , and at the same time old bundle X 0 was feasible when consumer had chosen new bundle X 1 . Real national income increased measured by new prices but declined measured by old prices. This is a strict violation of revealed preference principle or the weak axiom, and it means, that representative consumer preferences were changed. We depict preference shift for this numerical example on the following graph.

X2 X1

X0 Fig. 2 X1

It is clear from the graph, that indifference curves should intersect and preferences of representative consumer should shift. Because of this preference shift, we can not compare utility of equilibrium representative consumer before and after income redistribution, or before and after any other economic reform. It looks like utility of consumer increased as old bundle is feasible when he chooses new bundle W(u) X 1 , but at the same time from the view of original preferences, it looks like his utility declined, because he chooses bundle X 0 when new bundle is feasible. In the same way as interpersonal comparison of utilities is impossible, comparison of utilities of different equilibrium representative consumers is also impossible. Any economic reform, like money supply changes, trade, tax or tariff reform implies change in the efficient social welfare function that supports given economic equilibria. As a result, ex post representative consumer has different preferences than ex ante consumer and as a result it is impossible to use original ex ante social welfare function for the evaluation of efficient social welfare change. We arrive to conclusion that equilibrium representative consumer approach, or standard aggregated revealed preference approach for aggregate demand can not be used for the welfare evaluation of income redistribution or any other economic reforms that changes social welfare function that supports economic equilibria.

34 However, if efficient social welfare function does not change along adjustment path, then aggregated revealed preference approach still can be used. We arrive to the following postulate.
Postulate 1. Let original aggregated consumption bundle is strictly feasible at state 1 and parame-

ters of efficient social welfare function that supports a sequence of equilibria do not change along adjustment path : [ 0,1] Sl . Then new aggregated consumption bundle is not feasible at state 0 and state 1 represents higher efficient social welfare (level of efficient social welfare function) compare with state 0. The proof of the postulate is easy. If efficient social welfare function is fixed, then, as we have shown, aggregate demand along adjustment path is generated by the same equilibrium representative consumer for any price-income pair from equilibrium budget space. Then aggregate revealed preference approach is just standard revealed preference argument for the equilibrium representative consumer. The postulate states that change in the real national income measured both by the new and old prices is a correct measure of potential efficient social welfare change for any type of consumers preferences if and only if efficient social welfare function does not change. This implies a restriction on equilibrium budget space defined as above, and such restriction can in practice be very strong indeed. The examples of correct revealed preference approach applications include change in economy endowments and (or) technology. Any other changes are unmeasurable from the efficient social point of view. The next postulate is slightly tautological.
Postulate 2. Let equilibrium representative consumer prefer state 1 to state 0 in both states, 0 and

1. Then real total income is higher in state 1 compare with state 0 measured both by new and old prices, and we have sufficient conditions for the growth of efficient social welfare. The proof of the postulate is straightforward.

6. A Generalization of The Fundamental Welfare Theorems

In this section we intend to give answer to the general question of aggregation theory: can we every time represent society as an equilibrium representative consumer? To derive a positive answer, we first state a famous problem: why we observe imperfect competition with commodities prices above marginal costs of their production if it is not Pareto optimal allocation? Exactly, why economic agents do not trade off through mutually advantageous exchange and do not go to the Pareto optimal allocation if it is possible to make potential (and, if lump-sum payments are possible, and in real life they are possible, actual) Pareto improvement? Why Pareto-suboptimal allocations exist if they are not in the interest of egoistic economic agents? Second-best allocations imply perfect pos-

35 sibility of (potential) Pareto improvement as they are not Pareto optimal, then why we do not observe actual Pareto improvement in practice? The general theory of the market failure and the second best gives answer to this problem and our formulation of this general answer is that any second best allocation is constrained first best allocation. In other words, there are objective constraints, that prevent agents from being in the first best allocation. As these constraints are of the same level of objectivity as usual technological constraints, we can every time generalize fundamental welfare theorems, and such a generalization would be also a generalization of the famous Coase theorem. Economic theory states two types of objective constraints to possible Pareto improvements. First, it is existence of transaction costs, as in the Coase theorem. However, what are these transaction costs? They are just special cases of the minimal socially desirable production, or opportunity costs in the same fashion, as transportation costs! So, as we can every time include transportation costs into social production costs, we can also every time include transaction costs into these total production costs! If the market price is still above total social costs of production, including transaction costs, we still have a problem: allocation is not optimal, then why it exists if economic agents can easy move to the first best allocation simply by introducing lump-sum payments that are not illegal? If the market price is equal to the total social costs of production, including transaction costs, then we are done. So, in this case, as Dahlman (1979) claimed, observable equilibria are Pareto optimal given the existence of transaction costs. Second explanation offered by economic theory is existence of informational constraints that prevent potential or actual Pareto improvement or informational costs of potential Pareto improvement. See for example Ng (1977). However, here we can argue as McKee and West (1984) and claim that these informational costs can be easy included into our total social costs of production, or include these informational constraints into social production function, considering them as objective, fundamental constraints, that can not be eliminated in the same way, as can not be removed technological constraints! Or, as follows, we can consider these informational constraints as specific informational endowments, as endowments of specific resources information22. If, after these procedures, we still have a market price above social production costs, including necessary transaction and informational costs, then we still are in Pareto-suboptimal allocation, and problem is not solved, why here economic agents do not move to the Pareto optimal allocation if it is possible and profitable for them to move to it???? Our answer is, that in reality market price is already equal every time to the social production costs that are calculated including all types of socially necessary transaction and informational costs where each resource is valued by its fair mar-

22

Then we can claim that observable distortions work as part of the Paretian solution and their existence constitutes part of the first best allocation (see McKee and West 1984 and also Cullis and Jones 1998).

36 ket price, that is equal to the marginal product of this resource. This is what we call a generalization of fundamental welfare theorems.
Postulate 3. (A generalization of the First Fundamental Welfare Theorem, Coase Theorem with

information). Let economy: := H , N , , ( 1 ,... H ), = { } , ( w), ( F ), (G ), ( IC ) is endowed with the pool of information , technology , resource endowments (w) , set of legal constraints ( F ) , set of political constraints (G ) , set of incentive compatibility constraints ( IC ) and all other existed constraints and distribution of information between agents ( 1 ,... H ) , where H set of agents, N is a set of goods, is net output vector. Then any realistic, observable (achievable) and stable equilibrium ( p, x, ) is constrained Pareto optimal allocation ( x , ) given prices p, pool , distribution of information ( 1 ,... H ) , technology , sets ( F ) , (G ) , ( IC ) and endowments ( w ) . Proof: Let assume, contrary, that existed stable equilibrium is not constrained Pareto optimal. Then there exists an agent h such that it has information from the pool (that belong also to his information endowment h ) that it is possible given the endowment set ( w ) and sets of all types of constraints to improve utility of agent k without reduction of other agents utility. It means that given transaction costs (that are already reflected by technology ) and informational costs (that are covered in endowments ( 1 ,... H ) ) of such Pareto-improvement, increase in the gross utility of agent

k would be larger than all associated costs incurred by this consumer. Then being rational, agent h
would initiate voluntary trade, or mutual change in actions, with other agent(s) until all advantages of trade would be exhausted and equilibrium would achieve (constrained) Pareto optimal allocation. But it means that existed observable equilibrium is not stable a contradiction. Q.E.D. The Postulate claims that observable stable equilibria can be represented as specific Walrasian equilibria with transfers. We can go even further. All types of constraints depicted in the postulate 3 can be modeled as specific public and private goods and specific information goods (information also can be modeled as a mixed public good) endowments, such that constraints in the constrained second best simply reflect scarcity of specific public or private goods in the given economy. Such scarce public goods may include: efficient markets as a specific public goods, market infrastructure, protection of private property rights, well specified property rights, modern economic education and so on. Especially such public goods are important for the economies in transition, where under-provision of these goods was important reason of economic decline and growth of income inequality. Then we can consider full list of available public and private goods N+L, where L - additional set of public (private) goods that represent a set of all constraints except original technological constraint. If

37 we map this full set N+L into (aggregated) production set then this augmented aggregated production set = { } will be not only convex but exhibit only constant returns to scale. Exactly, assume that Russia produces some list of output. Then two Russia would produce exactly twice amount of initial output this means that we doubled all existed goods and endowments. Then, given such augmented aggregated production set any realistic equilibrium is (constrained) Pareto optimal allocation by the same reason as before. Summarizing, we have the following postulate.
Postulate 4. Let economy := H , N + L, = { } , ( w) is endowed with full set of goods and en-

dowments. Then any realistic and stable equilibrium with transfers ( ~, ~, ) is Pareto optimal alp x ~ ~ location ( ~ , ) given prices ~ and augmented production set . Conversely, any real allocation x ~ p
( ~, ) can be represented as quasi-Walrasian equilibrium with transfers ( ~, ~, ) . x ~ p x ~

Applying the postulates to observable situations of imperfect competition, we can say that in reality these situations are simply Walrasian equilibria with transfers, where workers pay transfers to businessmen, in most cases. These transfers are hidden in a system of distorted prices. Important corollary from the postulate is that any observable economic equilibrium can be represented by some efficient social welfare function and, respectively, by some equilibrium representative consumer. However, we are not guaranteed that any observable sequence of equilibria is rationalized by the same equilibrium representative consumer. As a result, society as a total is every time rational, but change in the efficient social welfare is generally un-measurable, if we have different structural changes such as economic reforms, wars or revolutions. Consumer surplus, with some modifications, can be used for evaluation of economic changes in any environment, including imperfect competition, only additional goods (such as informational) should be added to the model.

7. Conclusion
In our paper we extended and confirmed general results of Chipman and Moore (1976) concerning of the application of Marshallian surplus concept in the general class of consumer preferences (not quasilinear ones). We had proved that consumer surplus is a correct measure of individual utility along subset of (piecewise) monotonous parameterizations and so it can be used in rather general environments. Similar conclusion follows for the social aggregate consumer surplus. If efficient social welfare function that supports a sequence of equilibria has stable parameters along the adjustment path, change in efficient social welfare is identically equal to the aggregate generalized consumer surplus calculated along (piecewise) monotonous adjustment path. The same result will be reproduced in a dynamic general equilibrium model that is a Cartesian product of static economies. Finally, generalization of fundamental welfare theorems and Coase theorem states that aggre-

38 gate consumer surplus can be used even in distorted equilibria, that are essentially should be Walrasian equilibria with transfers (with limited endowments of marketable information).

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