1. Introduction to welfare economics

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5. 4 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.

6. 5 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

7. 6 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.

8. 7 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.

9. 8 Competitive equilibrium and Pareto-efficiency  At any output such as Q 1 *, the last film must yield consumers P 1 * extra utility.  The supply curve for the competitive film industry (SS) is the marginal cost of films.  Away from P 1 *, Q 1 *, 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 D Q1*Q1* P1*P1* Quantity of films Price of films

10. 9 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

11. 10 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.

12. 11 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 áe.g. a chemical firm discharges waste into a lake & ruins the fishing for anglers

13. 12 A production externality Quantity Price DD Suppose DD represents the demand curve for a product (which we may interpret as marginal social benefit). MPC MPC is the marginal private cost incurred by the firm in producing the good (assumed constant for simplicity). P Q The market clears where MPC=DD at price P and quantity Q.

14. 13 A production externality Quantity Price 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 welfare loss to society from the market failure is given by the excess of MSC over MPC between Q* and Q.

15. 14 A consumption externality DD MPC, MSC Quantity Price Q A consumption externality may cause marginal social benefit to diverge from marginal private benefit. If MSB>MPB, then the free market equilibrium provides the quantity Q. MSB Q' As compared with the social optimum at Q', where MSB = MSC. The red area shows the welfare loss. E.g. neighbours may benefit from a well-kept garden.

16. 15 Greenhouse gases

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