Transcript Document

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
SS
D
P1*
D
• At any output such as Q1*,
the last film must yield
consumers P1* extra utility.
• The supply curve for the
competitive film industry
(SS) is the marginal cost of
films.
• Away from P1*, Q1*, 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.
Q1*
Quantity 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)
Suppose DD represents
the demand curve for a
product (which we may
interpret as marginal
social benefit).
D
P
MPC
D
Q
Quantity
©McGraw-Hill Education, 2014
MPC is the marginal
private cost incurred by
the firm in producing
the good (assumed
constant for simplicity).
The market clears where
MPC = DD at price P and
quantity Q.
A production externality (2)
MSC
If the firm causes pollution,
it imposes costs on society,
presented by marginal
social costs (MSC).
So the social optimum is
where DD(MSB)=MSC at Q*.
The overall welfare
MPC loss to society from
the market failure is
DD
given by the excess
(MSB) of MSC over MPC
between Q* and Q.
Q* Q Quantity
©McGraw-Hill Education, 2014
A consumption externality
E.g. neighbours may benefit from a well-kept garden.
Price
MPC,
MSC
MSB
DD(MPB)
Q Q'
Quantity
As a consequence of a
consumption externality
MSB>MPB, and the
free market equilibrium
provides the quantity Q.
As compared with
the social optimum
at Q', where MSB =
MSC.
The pink area shows the
welfare loss.
©McGraw-Hill Education, 2014
A brief history of global temperatures
©McGraw-Hill Education, 2014
CO2 emissions 1850-2004
©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
1990.
• 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