CHAPTER 13 Welfare economics ©McGraw-Hill Education, 2014

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 Education, 2014

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 Education, 2014

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 Education, 2014

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 Education, 2014

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 Education, 2014

Distortions & the theory of the second best 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 Education, 2014

Market failure 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 include those concerned with future goods, risk, information ©McGraw-Hill Education, 2014

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 Education, 2014

A production externality (1) 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 Education, 2014

Q* So the social optimum is where DD(MSB)=MSC at Q*. A production externality (2) 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 Education, 2014

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 pink area shows the welfare loss. ©McGraw-Hill Education, 2014

A brief history of global temperatures ©McGraw-Hill Education, 2014

CO2 emissions ©McGraw-Hill Education, 2014

Annual greenhouse gas emissions per country in 2004 – % of world total ©McGraw-Hill Education, 2014

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 Education, 2014

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 Education, 2014

Concluding comments (1) Welfare economics deals with normative issues or value judgements. Horizontal equity is the equal treatment of equals, and vertical equity the unequal treatment of unequals. A resource allocation is a complete description of what, how and for whom goods are produced. An allocation is Pareto-efficient if no reallocation of resources would make some people better off without making others worse off. ©McGraw-Hill Education, 2014

Concluding comments (2) Distortions occur whenever free market equilibrium does not equate marginal social cost and marginal social benefit. Distortions lead to inefficiency or market failure. When only one market is distorted the first-best solution is to remove the distortion, thus achieving full efficiency. The theory of the second-best says that it is more efficient to spread inevitable distortions thinly over many markets than to concentrate their effects in a few markets. ©McGraw-Hill Education, 2014

Concluding comments (3) Production externalities occur when actions by one producer directly affect the production costs of another producer, as when one firm pollutes another’s water supply. Consumption externalities mean one person’s decisions affect another consumer’s utility directly, as when a garden gives pleasure to neighbours. ©McGraw-Hill Education, 2014