Welfare Economics

Welfare Economics
• Concerned with how well an economy
operates in terms of efficiency and
equity/social justice
• Efficiency - allocation of resources
• Equity - distribution of income

2
 Pareto Efficiency
• An allocation of commodities and inputs is
Pareto Efficient if the only way to make one
individual better off is to make another
worse off

3
 Three Conditions for Efficiency
• Production Efficiency
– “maximum” output
• Consumption Efficiency
– “maximum” utility
• Product-Mix (Allocation) Efficiency
– optimum mix of commodities

4
 Production Efficiency
• An allocation of inputs is production
efficient if the only way to increase the
output of one commodity is to decrease the
output of another commodity

5
 Production Efficient Allocations
Wine
0'
Production efficient B4
allocations
B3
h
B2 k
Capital

B1
l W1
j W2
W3

W4
0
Bread Labour 6
Production Efficiency Condition
• The MRTS between capital and labour must
be equal for all commodities

MRTS Bread
K ,L = MRTS Wine
K ,L

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Marginal Rate of Transformation
• The MRT is the rate at which the economy
can transform one output into another by
shifting its resources
– the (negative of the) slope of the production
possibilities curve

MC B
MRTV , B =
MCV
8
Production Possibilities Curve
Wine
j'

MCb

h' MCv k'

Bread
9
 Consumption Efficiency
• An allocation of commodities is
consumption efficient if the only way to
make one person better off is to make
another person worse off.
• The MRS between each pair of goods must
be equal for all consumers.

MRS Cain
V ,B = MRS Abel
V ,B
2
 Consumption Efficient
Allocations Abel
0'
Contract curve C4
C3
h
C2 k
Wine

C1
A1
j A2
A3

A4
0
Cain Bread 3
 Product-Mix Efficiency
• A mix of commodities is allocation efficient
if the MRT between any two goods is equal
to consumers’ common MRS between the
two commodities

MRTV , B = MRS Cain , Abel

V ,B

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 Pareto Efficiency
Wine

MRSVC,,BA = MRTV , B

Abel
f

A Pareto
efficient m
allocation
n

Cain
0
Bread
5
 Utility Possibilities Frontier
• A graph that shows the maximum amount
of utility an individual can obtain, given
another’s level of utility
• The locus of all Pareto efficient points

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 Utility Possibilities Frontier
Abel’s utility

n'

m'

Cain’s utility 7
 First Fundamental Theorem
• If all producers and consumers act as price-
takers and there is a market for every
commodity,
commodity the equilibrium allocation of
resources is Pareto efficient.
• Price-taking: perfect competition
• Complete set of markets
– perfect information, no externalities or public
goods
8
 “Proof” of 1st Welfare Theorem
• Production Efficiency
w
MRTS K , L = = MRTS K , L
Bread Wine

r
• Consumption Efficiency
PB
MRSV , B =
Cain
= MRSVAbel
,B
PV
• Product-mix Efficiency
PB MC B
MRSV , B =
C,A
= = MRTV , B 9
PV MCV
 Second Fundamental Theorem
• Provided that all indifference curves and
isoquants are convex, for each Pareto
efficient allocation of resources there is a
set or prices that can attain that allocation as
a general competitive equilibrium
• To attain any Pareto efficient allocation (i.e.
point on the utility possibilities frontier),
use lump-sum taxes and transfers
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 Theory of the Second Best
• If a first best allocation is impossible to
obtain, a second best allocation may
involve the introduction of additional
wedges between price and marginal cost.
• E.g. if price not equal to MC in a related
market, then second best policy in this
market may also be to not set price equal to
MC
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 Review of First Best Model
• Production Efficiency First
Fundamental
w
MRTS Bread
K ,L = = MRTS K , L
Wine Theorem
r If all producers
• Consumption Efficiency and consumers
act as price-
PB takers and there
MRS Cain
V ,B = = MRSVAbel
,B is a market for
PV every
commodity,
commodity the
• Product-mix Efficiency equilibrium
allocation of
PB MCB resources is
MRS C,A
V ,B = = = MRTV , B Pareto efficient.
PV MCV
 Social Justice/Equity
• Pareto efficient allocation is not unique
– All points on grand utility possibility frontier
are Pareto efficient
• Need a Social Welfare Function to choose
the social optimum
W = W (U , U )
Abel Cain

• Social Justice Condition

Slope of isowelfare curve = slope of utility frontier
 Social Optimum
UA
E is the constrained
bliss point

T is efficient but lower

social welfare than E

S is inefficient but
preferred to T
S E
W2
T W1

UC
 Social Welfare Function (SWF)
• Shows how total social welfare depends on the
welfare/utility of individuals
W = W U ,U ( Abel Cain
)
• General properties are:
– Welfarism
– Strong Pareto Criterion
– Convexity
– Anonymity
 Types of SWF
• Given ordinal & non-comparable individual
utility functions no SWF exists (except
dictatorship)
• Given measurability and comparability of
utility levels, a SWF is possible
– Simple utilitarian (Benthamite)
– Generalised utilitarian
– Rawlsian (maxmin)
 First Best Policy Rules
• Given income distribution, social welfare is
maximised at point A where
MRSV , B = MRTV , B
• MRS = MSB, MRT = MSC, so first best rule is
MSBB = MSCB
• In a perfect market MSB = demand curve & MSC
= supply curve. Hence first best pricing rule is

P = MSC
 Units o f Wine
A
CI1

Units of Bread

Units of
Wine
given up
MSC(S)

MSB(D)

Units of Bread