1 of 43

1

• Social Efficiency

• Social efficiency When there is no free
  lunch. Someone has to pay.
• Autarky, trade, and free lunch.
• A PARETO-efficient state is where the is no more
  free lunch.
• A Pareto-efficient state is when on cannot make
  someone better off without making somebody else
  worse off.
• Having a free lunch is referred to as a Pareto
  improvement or making a Pareto improving move.
• Pareto improvement Making someone better off
  without making anybody else worse off (as in free
  trade).

2

• Social Efficiency and Competitive Markets

• A competitive market tends to realize all free
  lunches.
• A competitive market is Pareto efficient.
• This is called The First Fundamental Theorem of
  Welfare Economics.

3

• Every individual necessarily labours to render
  the annual revenue of the society as great as he
  can. He generally indeed neither intends to
  promote the public interest, nor knows how much
  he is promoting it . He intends only his own
  gain, and he is in this, as in many other cases,
  led by an invisible hand to promote as end which
  was no part of his intention.
• Adam Smith, The Wealth of Nations, Book IV

4

• Equilibrium and Social Welfare

Equilibrium
5
Social Efficiency
Social efficiency represents the net gains to
society from all trades that are made in a
particular market, and it consists of two
components consumer and producer surplus.
consumer surplus The benefit that consumers
derive from consuming a good, above and beyond
the price they paid for the good.
6
Social Efficiency
7
Producer Surplus
producer surplus The benefit that producers
derive from selling a good, above and beyond the
cost of producing that good.
8
Producer Surplus
9
Social Surplus
total social surplus (social efficiency) The sum
of consumer surplus and producer surplus.
10
Social Surplus
11
Competitive Equilibrium Maximizes Social
Efficiency
First Fundamental Theorem of Welfare Economics
The competitive equilibrium, where supply equals
demand, maximizes social efficiency.
deadweight loss The reduction in social
efficiency from denying trades for which
benefits exceed costs.
12
From Social Efficiency to Social Welfare The
Role of Equity
social welfare The level of well-being in
society.
Governments have certain redistributive programs
because their citizens care not only about
efficiency but also about equity, the fair
distribution of resources in society. The
competitive equilibrium, while being the social
efficiency-maximizing point, may not be the
social welfare-maximizing point.


13
equityefficiency trade-off The choice society
must make between the total size of the economic
pie and its distribution among individuals.
14
From Social Efficiency to Social Welfare The
Role of Equity
social welfare function (SWF) A function that
combines the utility functions of all individuals
into an overall social utility function.
15
The Social Welfare Function WW(.)

• The basis idea of the SWF is to make the
  societys notion of fairness explicit.
• Introduced by Samuelson and Bergson some fifty
  years ago.
• Often people talk about being fair without
  specifying what they mean
• John Edwards often talks about two Americas.
• Is it only two? What does one America look
  like?
• Bill Clinton, in his 92 presidential campaign,
  talked about an America in which the wealthiest,
  those making over 200,000 dollars a year, are
  asked to pay their fair share.

16
The Social Welfare Function WW(.)

• But one can interpret this as
• Higher income people should pay more taxes. If we
  accept this interpretation we are still left with
  the question of How much?
• Higher income people pay more in terms of average
  taxes. But again How much?
• Higher income people pay more in terms of
  marginal taxes. But again How much?
• William Safire, a previous columnist for New York
  Times, defines tax fairness as the poor should
  pay nothing, the middlers something, and the rich
  the highest percentage. So his is in terms of
  averages. But the question of how much still
  remains.

17
Some Specific Examples
Utilitarian SWF
With a utilitarian social welfare function,
societys goal is to maximize the sum of
individual utilities SWF U1 U2 . . .
UN The utilities of all individuals are given
equal weight, and summed to get total social
welfare.
18
Linear Iso-Welfare Curves
U2
U1

• Same MRS everywhere perfect substitute
• Jeremy Bentham Utilitarianism

19

20
Rawlsian Social Welfare Function

• John Rawls suggested that societys goal should
  be to maximize the well- being of its worst-off
  member. The Rawlsian SWF has the form
• SW min (U1, U2, . . ., UN)
• Since social welfare is determined by the minimum
  utility in society, social welfare is maximized
  by maximizing the well-being of the worst-off
  person in society.
• Deciding under the veil of ignorance.

21
L-shaped Iso-Welfare Curves
45
U2
U1
Perfect complements
22
John Rawls
23

• Atkinson social welfare function
• e is the Inequality Aversion Parameter.
• We have
• -As to a Utilitarian SWF
• -As to a Rawlsian SWF

24
Anthony Atkinson
25
(No Transcript)
26

• NOZIK Equality of opportunity not outcomes
• The principle that society should ensure that all
  individuals have equal opportunities for success,
  but not focus on the outcomes of choices made.
• The island example
• The measurement problem
• Ex-ante versus Ex-post

27
Robert Nozick
28
Another idea
Commodity Egalitarianism The principle that
society should ensure that individuals meet a set
of basic needs, but that beyond that point income
distribution is irrelevant.
29

• Conclusion

• The notion of Pareto efficiency.
• The relationship between competitive markets
  and efficiency.
• Market failures.
• Efficiency gain and loss calculations.
• Equity and efficiency tradeoff.
• The notion of a social welfare function.
• Different types of SWF.