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Lecture 1

Social preferences
Two approaches in identifying
society’s preferences
• The positive approach
• Identifies the preferences and objectives held by a given society
in a certain period.
• Used when we want to determine the specific content of public
intervention
• The normative theory of social choice
• Identifies the preferences and objectives that a society should
have on the basis of some ethical or political postulate about the
meaning of collective interest or public good
• The normative approach= welfare economics
• Primarily concerned with defining the criteria of social choice
• Then uses these criteria to assess economies and identify most
desirable
Constructing a social ordering
• A social ordering
• Ranking of the possible situations in which society
may find itself
• Ordering has certain properties (transitivity, etc.)
• The social ordering can be expressed as a function
• a “social welfare function”
• Issues to be solved in constructing a social ordering
• Choosing between direct and indirect social
ordering
• Choosing between different methods of
aggregating individual preferences in the case of
indirect orderings
Choosing between direct and
indirect social orderings
• Direct social ordering, example
• Equality as an external principle
• Gini coefficient
• Indirect social ordering
• On the basis of some external criterion, it is
constructed in relation to the preferences of individuals
• Welfare economics and ethical individualism
• Each individual is the best judge of her preferences
• The value of possible social states is determined by the
individual’s perception of these states
Objections to indirect orderings

1. The social ranking must only take into account the satisfaction
effectively enjoyed by individuals at a certain point in time.
• Example
• We cannot take into account the initial distribution of
income when looking at the current redistribution of income
2. In reducing the situation in society to the satisfaction of
individuals, the latter’s preferences are often considered to be
given (exogenous).
• However, in reality, preferences are endogenous, i.e. affected
by many social and economic factors: habits, fashion, social
norms
Aggregating individual
preferences
• Different individual preferences make it difficult to determine an
aggregate preference function.
• Controversial aspects of aggregation:
• The representation of individual preferences, with particular
regard to the measurement of satisfaction
• Ordinal and cardinal measures
• The possibility of comparing the positions of different individuals
• Is it possible?
• The aggregation rule
• Sum satisfactions (when preferences are measured cardinally)
• Only partial social ranking (when preferences are measured
ordinally)
Information about individual utilities
and interpersonal comparisons

• Problems arising from invariance requirements


• Measuring individual utilities
• Comparing individual utilities
• In measuring utilities, we have information related to
• Ordinal measurability
• Cardinal measurability
• Ratio scale measurability
• Absolute scale measurability
Information about individual utilities
and interpersonal comparisons (cont.)
• Ordinal measurability
• Requires minimal information
• Example: Pareto indifference curves
• We can only determine the sign of the change in the utility (increasing
or decreasing), but not the magnitude
• Cardinal measurability
• Provides more information than ordinal measurability
• We can compare absolute changes in utility
• Ratio scale measurability
• We can not only compare absolute changes in utility, but also
proportional changes
• Absolute scale measurability
• Offers maximum information regarding individual utilities
• We assign a unique real number to each satisfaction
Pareto and new welfare
economists

• Personal utility cannot be measured cardinally

• The positions of different individuals are


fundamentally non-comparable
Aggregating non-comparable ordinal
preferences and the Pareto principle
• Weak Pareto criterion
• A group of individuals increases its welfare by moving from
state A to state B if all the individuals are more satisfied in B
than in A.
• Strong Pareto criterion
• The group of individuals increases its welfare in moving from A
to B if at least one individual is better off in B and no individual
is worse off.
• From the strong Pareto principle, we can derive a Pareto optimum
(efficiency)
• A social state A is Pareto optimal if in moving from that state to
any other state it is not possible to increase the welfare of any
member of society without worsening the condition of at least
one other.
Consumption efficiency

• Utilities possibilities curves (UPC)


• Allocation of consumption can be Pareto improved as long as two individuals
have a different marginal rate of substitution (MRS)
• Pareto optimality
• The marginal rates of substitution (MRS) of all the members of society for
each pair of good are equal
Edgeworth box diagram and the
contract curve
Efficiency in a production
economy
• Consumption efficiency
𝑀𝑅𝑆𝐴 = 𝑀𝑅𝑆𝐵
• Production efficiency
𝑀𝑅𝑇𝑆𝐿 = 𝑀𝑅𝑇𝑆𝐾

• Input supply efficiency


• The input contract curve
• The production possibility frontier
• ‘General’ efficiency
• Marginal rate of transformation (MRT)

𝑀𝑅𝑇𝑋𝑌 = 𝑀𝑅𝑆𝑋𝑌
Production possibility frontier
Utility possibility frontier
• COPY FIGURE 3.5
Limitations of the theory of
general equilibrium

• Static nature
• The maximisation hypothesis
• The exogenous nature of preferences
• High degree of abstraction
Limitations of the Pareto
efficiency criterion
• Ignores important aspects of the various states of the
world
• Liberties and rights, quantity and distribution of
goods
• Provides only a partial ordering of social states
• We cannot define an ordering among efficient
social states
• We cannot define an ordering among some
inefficient and efficient social states
• Different initial positions admit different sets of
Pareto superior positions
Define ordering between d, c and h
Define ordering between a and d or a and e
New welfare economics- the
compensation principle (Kaldor, 1939)
• A change that lead to an increase in productivity, and therefore
in society’s real income, would increase the welfare of society
as a whole, since those who benefitted from the change would
be able to compensate those who were worse off while retaining
a net benefit.
• The possibility of paying compensation would be enough to
judge the change favourably.
• Criticism
• The effective payment of the compensation
• Whether the change can be evaluated solely in terms of its
effects on total income, overlooking the actual distribution
of wealth
Consider the change from a to e
Scitovsky’s ‘double’ criterion

• Double criterion
• In moving from one state to another, one individual
can compensate the other and still be left with a net
benefit (as proposed by Kaldor)
• The individual who is worse off by change cannot
pay the individual who is better off to remain in the
initial state
Scitovsky’s ‘double’ criterion
Arrow and the impossibility
theorem
• Arrow (1951) tried to construct a complete social ordering.
• He introduced additional conditions that enable us to order
Pareto non-comparable states as well.
• An unrestricted domain condition
• An independence of irrelevant alternatives condition
• Practical significance – a dictatorship in determining social
preferences
• No dictatorship = a partial social ordering
• Dictatorship = a complete ordering that overcomes the
partial character of the Pareto principle while still applying
the principle itself.
Majority voting
• Only two options: Arrow’s impossibility theorem does not hold
Voter 1 Voter 2 Voter 3
A B B
B A A

• More than two options: Arrow’s impossibility theorem holds


Voter 1 Voter 2 Voter 3
A C B
B A C
C B A