Chapter 16Introduction to welfare economics

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,

6th Edition, McGraw-Hill, 2000

Power Point presentation by Peter Smith

16.2

Welfare economics

The branch of economics

dealing with normative issues.

Its purpose is not to describe

how the economy works

but to assess how well it works.

16.3

Equity and efficiency

Horizontal equity– the identical treatment of identical

people

Vertical equity– the different treatment of different

people in order to reduce the consequences of their innate differences

16.4

Pareto efficiency

An allocation is Pareto-efficient for a given set of consumer tastes, resources and technology, if it is impossible to move to another allocation which would make some people better off and nobody worse off.

16.5

Perfect competition and Pareto efficiency

If every market in the economy is a perfectly competitive free market, the resulting equilibrium throughout the economy will be Pareto-efficient.

As expressed in Adam Smith’s notion of the Invisible Hand.

16.6

Competitive equilibrium and Pareto-efficiency

At any output such as Q1*, the last film must yield consumers P1* extra utility.

The supply curve for the competitive film industry (SS) is the marginal cost of films.

Away from P1*, Q1*, there is a divergence between the marginal cost and the marginal benefit derived by consumers

so a move to that position makes society better off.

D

SSD

Q1*

P1*

Quantity of films

Pric

e of

film

s

16.7

Distortions

A distortion exists whenever society’s

marginal cost of producing a good does not

equal society’s marginal benefit from

consuming that good.– Some such distortions may be inevitable

– and it may be more efficient to spread such

distortion over a wide range of markets, rather than

concentrating it in one market

– this results from the theory of the second-best

16.8

Market failure

… occurs when equilibrium in free unregulated markets will fail to achieve an efficient allocation.

Imperfect competition Social priorities (e.g. equity) Externalities Other missing markets

– future goods, risk, information.

16.9

Externalities

An externality arises whenever an individual’s production or consumption decision directly affects the production or consumption of others…

other than through market prices e.g. a chemical firm discharges waste

into a lake & ruins the fishing for anglers

16.10

A production externality

Quantity

Pri

ce

DD

Suppose DD represents the demand curve for a product (which we mayinterpret as marginalsocial benefit).

MPC

MPC is the marginalprivate cost incurred bythe firm in producing the good (assumed constant for simplicity).

P

Q

The market clears whereMPC=DD at price P and quantity Q.

16.11

A production externality

Quantity

Pri

ce

DD(MSB)

MPC

Q

MSC

If the firm causes pollution,it imposes costs on society, presented by marginal social costs (MSC).

Q*

So the social optimum is where DD(MSB)=MSC at Q*.

The overall welfareloss to society from the market failure is given by the excess of MSC over MPC between Q* and Q.

16.12

A consumption externality

DD

MPC, MSC

Quantity

Pri

ce

Q

A consumption externalitymay cause marginal social benefit to diverge from marginal private benefit.

If MSB>MPB, then the free market equilibriumprovides the quantity Q.

MSB

Q'

As compared with thesocial optimum at Q', where MSB = MSC.The red area shows thewelfare loss.

E.g. neighbours may benefit from a well-kept garden.

16.13

Greenhouse gases

0

20

40

60

80

100

120

Index (1990 = 100)

Japan

USA

Germ

any

UKIta

ly

Emission of greenhouse gases

1990

1995

2012