Economics by David Begg, Gianluigi Vernasca, Stanley Fischer & Rudiger Dornbusch TENTH EDITION ©McGraw-Hill Companies, 2010 Chapter 13 Welfare economics

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. ©McGraw-Hill Companies, 2010

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 ©McGraw-Hill Companies, 2010

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. ©McGraw-Hill Companies, 2010

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 ©McGraw-Hill Companies, 2010

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 ©McGraw-Hill Companies, 2010

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. ©McGraw-Hill Companies, 2010

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 ©McGraw-Hill Companies, 2010

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 ©McGraw-Hill Companies, 2010

A production externality Quantity Price D 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. D ©McGraw-Hill Companies, 2010

Q* So the social optimum is where DD(MSB)=MSC at Q*. 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). The overall welfare loss to society from the market failure is given by the excess of MSC over MPC between Q* and Q. ©McGraw-Hill Companies, 2010

A consumption externality DD(MPB) Quantity Price Q MPC, MSC As a consequence of a consumption externality MSB>MPB, and the free market equilibrium provides the quantity Q. MSB Q' As compared with the social optimum at Q', where MSB = MSC. E.g. neighbours may benefit from a well-kept garden. The brown area shows the welfare loss. ©McGraw-Hill Companies, 2010

A dramatic rise in global temperature ©McGraw-Hill Companies, 2010

CO2 emissions ©McGraw-Hill Companies, 2010

CO2 emissions, 2008 (% of global total) Source: CO 2 Emissions from Fuel Combustion (2010 Edition), IEA, Paris. ©McGraw-Hill Companies, 2010

Kyoto Protocol Began 1997 By 2006, 169 countries had signed, (not including the US). By 2012, emissions will be 5% lower than in Various schemes are in place, including carbon trading. ©McGraw-Hill Companies, 2010

Is it worth it? Should China cut back today to make the future better? The Stern review concluded that 1% of global GDP must be invested from now on if we are to head off the worst effects of climate change, and that failure to act now risks a future cost of up to 20% of global GDP. ©McGraw-Hill Companies, 2010