Chapter 16 Introduction to welfare economics David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith

16.1 Welfare economics n The branch of economics dealing with normative issues. n Its purpose is not to describe how the economy works n but to assess how well it works.

16.2 Equity and efficiency n Horizontal equity – the identical treatment of identical people n Vertical equity – the different treatment of different people in order to reduce the consequences of their innate differences

16.3 Pareto efficiency n 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.

16.4 Perfect competition and Pareto efficiency n If every market in the economy is a perfectly competitive free market, the resulting equilibrium throughout the economy will be Pareto-efficient. n As expressed in Adam Smith’s notion of the Invisible Hand.

16.5 Competitive equilibrium and Pareto-efficiency n At any output such as Q 1 *, the last film must yield consumers P 1 * extra utility. n The supply curve for the competitive film industry (SS) is the marginal cost of films. n Away from P 1 *, Q 1 *, there is a divergence between the marginal cost and the marginal benefit derived by consumers n so a move to that position makes society better off. D SS D Q1*Q1* P1*P1* Quantity of films Price of films

16.6 Distortions n 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

16.7 Market failure n … occurs when equilibrium in free unregulated markets will fail to achieve an efficient allocation. n Imperfect competition n Social priorities (e.g. equity) n Externalities n Other missing markets – future goods, risk, information.

16.8 Externalities n An externality arises whenever an individual’s production or consumption decision directly affects the production or consumption of others… n other than through market prices á e.g. a chemical firm discharges waste into a lake & ruins the fishing for anglers

16.9 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.

16.10 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.

16.11 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.

16.12 Greenhouse gases