Welfare measurement: aggregate (Cost Benefit Analysis DEC 51304) Z&D 6 R. Jongeneel

Lecture Plan  Aggregation problem  Social welfare function  Kaldor-Hicks & Potential Pareto Criterion  Aggregation of CS and PS  Ambiguities  BC-A and assignment of rights  Human perception of gains and losses

Aggregation Problem  Economic efficiency is consistent with many different utility and income distributions  Example 1:  Example 2:  Example 3:  Impossibility of interpersonal utility comparisons

Aggregation Problem A B C A and B are Pareto non-comparable PP is (grand) utility possibility frontier (UPF)

Social Welfare Function (SWF)  Social choice problem  Samuelson-Bergson SWF  Change

Social Welfare Function Denote: marginal utility of h’s income (MU h ) marginal social utility of h (MSU h )

SWF: efficiency and distribution  efficiency term (income effect):  distribution term:  marginal social utility of h’s income:

SWF and distribution with interdependent utility (fundamental equation normative analysis)

Kaldor-Hicks & Potential Pareto Criterion  Compensation tests Potential Pareto Improvement  Kaldor: The winners from a project could in principal compensate the losers from the project

Kaldor-Hicks and Potential Pareto Criterion  Hicks: the losers of the project could not bribe the winners not to undertake the project Change: PP  RR (A  B) Kaldor: B > A Hicks: A > B R P C A D B R P

Kaldor-Hicks and Potential Pareto Criterion  By considering hypothetical compensation the focus is on efficiency  A Pot.Par. Improvement is not an actual PPI  The Com. principles consistently rank any Par. optimal allocation above any allocation that is not Pareto optimal  Pareto optimal allocations are simply not comparable  Comp. principles cannot completely rank social states

Is there a way out?  Scitovsky: Both the Kaldor and Hicks criteria are met (PPI)  Welfare change with Kaldor-Hicks  NB: Kaldor-Hicks approach ignores distributional aspects but can account for utility interdependence

Aggregation of CS and PS  Aggregation of EV’s H A+B quantity price P0P0 P1P1 HAHA HBHB A B C

Aggregation of Consumer Surplus H aggr quantity price P0P0 P1P1 HAHA HBHB A B C

Aggregation of CV and EV  A necessary condition for the (weak) Kaldor compensation test to be passed is  A sufficient condition for the (weak) Hicks compensation test to be passed is  Aggregate CV and EV measures are best considered as preliminary attempts to rank social states

Aggregation of Producer Surplus Change P 0  P 1 Ps aggr = A+B+C No aggregation problem on the producer side! quantity price P1P1 P0P0 A B C SASA SBSB S A+B

Aggregation Example: Airport and Noise I without airport and noise, II with airport and noise

BC-A and assignment of rights  Starting point is determined by assignment of rights  If residents right to quiet: CV( I  II ) is relevant  If airport has right to exist: EV( I  II ) is relevant  Assignment of property rights can be important in BC-A for cases with big differences between WTP and WTA figures

Human perception of gains and losses  Behavioral economics: loss aversion  Endowment effect or status quo-bias  Not only rights but also losses from positions people feel themselves entitled to are important

Human perception of gains and losses UhUh x +dx -dx Loss- aversion effect