Welfare Economic

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Welfare Economic

© All Rights Reserved

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Welfare Economics

need a starting point

economic theory concerned with the social

desirability of alternate economic states and policies

Chapter 2: Fundamentals of

Welfare Economics

Welfare Economics

First Fundamental Theorem of

Welfare Economics

Second Fundamental Theorem of

Welfare Economics

Theory - Starting Point:

Pure Exchange Economy

We start with a simple model:

2 people

2 goods, each of fixed quantity

Determine good allocation

The important results of this simple, 2-

person model hold in more real-world

cases of many people and many

commodities 3

Pure Exchange Economy

Example

Two people: Maka and Susan

Two goods: Food (f) & Video Games (V)

We put Maka on the origin, with the y-axis

representing food and the x axis representing

video games

If we connect a flipped graph of Susans

goods, we get an EDGEWORTH BOX, where y

is all the food available and x is all the video

games:

4

Makas Goods Graph

is Makas Video Games

Food

O x

Maka Video Games

5

Edgeworth Box Susan

r

y O Ow is Susans food,

and Oy is Susans

Video Games

Food

u w market is Or(=Os)

and total Video

Games is Os (=Or)

Each point in the

Edgeworth Box

O represents one

x s

possible good

Maka Video Games allocation 6

Edgeworth and utility

Makas graph (each curve indicating all

combinations of goods with the same utility)

Curves farther from O have a greater utility

(For a review of indifference curves, refer to

Intermediate Microeconomics)

We can then superimpose Susans utility

curves

Curves farther from O have a greater utility 7

Makas Utility Curves

Food

M3

M2

M1

O

Maka Video Games

8

Edgeworth Box and Utility

Susan

r O Susan has the

highest utility at S3

S1

S2 A

S3 At point A, Maka

Food

Susan has Utility of

M3 S2

M2

M1

O s

Maka Video Games

9

Edgeworth Box and Utility

Susan

r O If consumption is at

A, Maka has utility

M1 while Susan has

A utility S3

S3 B

Food

C By moving to point

B and then point C,

M3 Makas utility

M2 increases while

M1

Susans remains

constant

O s

Maka Video Games

10

Pareto Efficiency

Susan

r O Point C, where the

indifference curves

barely touch is

called PARETO

S3 EFFICIENT, as one

Food

C person cant be

made better off

M3

without harming the

M2

M1 other.

O s

Maka Video Games

11

Pareto Efficiency

is wasteful (at least one person could be

made better off)

Pareto efficiency evaluates the desirability of an allocation

A PARETO IMPROVEMENT makes one person better

off without making anyone else worth off (like the

move from A to C)

However, there may be more than one pareto

improvement:

12

Pareto Efficiency

Susan

r O If we start at point A:

-C is a pareto

improvement that

A makes Maka better

S3 off

Food

S4 C

-D is a pareto

S5 E improvement that

M3

makes Susan better

D M2

M1 off

-E is a pareto

improvement that

O s makes both better off

Maka Video Games

13

The Contract Curve

Assuming all possible starting points, we can

find all possible pareto efficient points and join

them to create a CONTRACT CURVE

All along the contract curve, opposing

indifferent curves are TANGENT to each other

Since the slope of the indifference curve is the

willingness to trade, or MARGINAL RATE OF

SUBSTITUTION (x for y) (MRSxy), along this

contract curve:

MRSVf Maka

MRSVf Susan

14

Pareto Efficiency Condition

The Contract Curve

Susan

r O

Food

O s

Maka Video Games

15

MATH House and Chase

Assume that house and Chase have the following

utilities and MRS for books and coffee:

U House

B C ,U

H H Chase

B CC C

MRS House

BC C / B , MRS

H H Chase

BC C /B , C C

MRS House

BC MRS Chase

BC ,

C /B C /B

H H C C

16

MATH House and Chase

If there are 10 books, and 4 cups of coffee, then the

contract curve is expressed as:

MRS House

BC MRS Chase

BC ,

C / B (4 C ) /(10 B )

H H H H

would be: H

C / 6 (4 C ) /(10 6)

H

4C 6(4 C )

H H

10C 24H

C 2.4

H 17

MATH House and Chase

Therefore, House would have 6 books and 2.4 cups

of coffee, and Chase would have 4 (10-6) books

and 1.6 (4-2.4) cups of coffee, for utilities of:

U House

B C

H H

6(2.4) 3.79

U Chase

B C 4(1.6) 2.52

C C

18

Theory - Starting Point:

Economy with production

A production economy can be analyzed using

the PRODUCTION POSSIBILITIES

CURVE/FRONTIER

The PPC shows all combinations of 2 goods that

can be produced using available inputs

The slope of the PPC shows how much of one

good must be sacrificed to produce more of the

other good, or MARGINAL RATE OF

TRANSFORMATION (x for y) (MRTxy)

Note that although the slope is negative, the negative is assumed and rarely shown

in simple calculations

19

Production Possibilities Curve

Here the MRTSpr is equal to (7-

10 5)/(2-1)=-2, or two robots must be

9 given up for an extra pizza.

8

The marginal cost of the 3rd pizza,

7 or MCp=2 robots

6

Robots

5 robots, or MCr=1 pizza

4

3 Therefore, MRTxy=MCx/MCy

2

Therefore, MRTpr=2/1=2

1

1 2 3 4 5 6 7 8

20

Pizzas

Efficiency and Production

If production is possible in an economy, the

Pareto efficiency condition becomes:

xy MRS PersonB

xy

Assume MRTpr=3/4 and MRSpr=2/4.

-Therefore Maka could get 3 more robots by

transforming 4 pizzas

-BUT Maka only needs to get 2 robots for 4 pizzas to

maintain utility

-Therefore his utility increases from the extra robot,

Pareto efficiency isnt achieved

21

Efficiency & Production Example

From the PPC, we know that:

MC x

MRT xy

MC y

We can therefore reinterpret Pareto efficiency

as:

MC x

MRS xy

PersonA

MRS xy

PersonB

MC y 22

Theory - First Fundamental

Theorem Of Welfare

Economics

IF

1) All consumers and producers act as perfect

competitors (no one has market power)

and

2) A market exists for each and every

commodity

Then

Resource allocation is Pareto Efficient

23

First Fundamental Theorem of

Welfare Economics Origins

From microeconomic consumer theory, we

know that: P

MRS PersonA

xy x

Py

Since prices are the same for all people:

MRS PersonA

xy MRS PersonB

xy

part of Pareto efficiency

24

First Fundamental Theorem of

Welfare Economics Origins

From basic economic theory, a perfect

competitive firm produces where P=MC,

therefore: MC P

x

x

MC y Py

But we know that MRT is the ratio of MCs,

therefore: P

MRTxy x

Py

25

First Fundamental Theorem of

Welfare Economics Origins

Again from microeconomic consumer theory,

this changes to:

MRT xy MRS xy

Which satisfies the second requirement of

Pareto Efficiency

Therefore, we can expand Pareto Efficiency to

imply that

MC x Px

MRTxy MRS xy

PersonA

MRS xy

PersonB

MC y Py

26

EfficiencyFairness

If Pareto Efficiency was the only concern,

competitive markets automatically achieve it

and there would be very little need for

government:

Government would exist to protect

property rights

Laws, Courts, and National Defense

But Pareto Efficiency doesnt consider

distribution. One person could get all

societys resources while everyone else

27

Fairness

Susan

r O

Pareto efficient, but

C either Susan or Maka

get almost all societys

Food

resources

A

Many would argue C is

better for society, even

though it is not Pareto

O s efficient

Maka Video Games

28

Fairness

For each utility level of one person, there is

a maximum utility of the other

Graphing each utility against the other gives us

the UTILITY POSSIBILITIES CURVE

Just as typical utility is a function of goods

consumed: U=f(x,y), societal utility can be

seen as a function of individual utilities:

W=f(U1,U2)

This is referred to as the SOCIAL

WELFARE FUNCTION, and can produce

29

Utility Possibilities Curve

All points on the curve are

Pareto efficient, while all

B points below the curve are

not.

Makas Utility

is unobtainable

C

O

Maka Susans Utility

30

Typical Social Indifference

Curves

An indifference curve

farther from the origin

Makas Utility

social welfare.

O

Maka Susans Utility

31

Fairness

If we superimpose social indifference

curves on top of the utilities possibilities

curve, we can find the Pareto efficient point

that maximizes social welfare

FUNDAMENTAL THEOREM OF WELFARE

ECONOMICS

32

Maximizing Social Welfare

ii is preferred to i, even

though ii is not Pareto

i efficient

Makas Utility

welfare, iii, is Pareto

iii efficient

O

Maka Susans Utility

33

Second Fundamental Theorem

of Welfare Economics

The SECOND FUNDAMENTAL THEOREM OF

WELFARE ECONOMICS states that society

can attain any Pareto efficient allocation of

resources by making a suitable

assignments of original endowments, and

then letting people trade

-Roughly, by redistributing income, society

can pick the starting point in the Edgeworth

box, therefore obtaining a desired point on

the Utility Possibility Frontier: 34

Second Fundamental Theorem

of Welfare Economics Susan

r O

Starting

Point

Goal

Food

O s

Maka Video Games

35

Why Income Redistribution?

Why achieve equity through income

redistribution instead of taxes/penalties and

subsidies/incentives?

Taxes and penalties punish income-

enhancing behavior, encouraging people to

work less.

Subsidies and incentives give an incentive to

stay in a negative state to keep receiving

subsidies and incentives.

Lump sum transfers have the least distortion.

36

Why Is Government so Big?

1) Government has to ensure property laws

are protected. (1st Theorem)

achieve equity. (2nd Theorem)

Theorem do not hold (Chapter 3)

37

Welfare Economics Limitations

We Assume: Government exists to maximize the

utility of its citizens.

achieve cultural goals, achieve religious goals, etc.

watching the Biggest Loser?

38

Merit Goods

provided even if society

a) doesnt want them

ie: police/fluorine in water

And/Or

market

ie: Canadian Broadcast Corporation

(CBC) 39

Welfare Economics Evaluation

-Welfare Economics is concerned with

RESULTS, not PROCESS

-contract law?

-Old Testament law?

-Lottery?

-Free-for-all wrestling match?

40

Welfare Economics Evaluation

Welfare Economics asks 3 questions of every

government action:

consequences?

2) Will it enhance efficiency?

3) Is the cost reasonable?

answer, they provide direction, and if they are all

41

no, the government shouldnt interfere

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