Chapter 16 Introduction to welfare economics

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Chapter 16Introduction to welfare economics

• David Begg, Stanley Fischer and Rudiger
  Dornbusch, Economics,
• 6th Edition, McGraw-Hill, 2000
• Power Point presentation by Peter Smith

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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.

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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

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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.

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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 Smiths notion of the
  Invisible Hand.

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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
SS
Price of films
P1
D
Q1
Quantity of films
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Distortions

• A distortion exists whenever societys marginal
  cost of producing a good does not equal societys
  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

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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.

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Externalities

• An externality arises whenever an individuals
  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

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A production externality
Price
Quantity
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A production externality
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A consumption externality
E.g. neighbours may benefit from a well-kept
garden.
A consumption externality may cause marginal
social benefit to diverge from marginal private
benefit.
If MSBgtMPB, then the free market
equilibrium provides the quantity Q.
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Greenhouse gases