Applied Welfare Economics - PDF Free Download

Economics Monika Köppl - Turyna Department of Economics ISCTE-IUL Summer 2014/2015

Introduction

We will have lectures and problem solving sessions (usually one per two lectures) Attendance is generally obligatory (the 80 % rule applies) Midterm and final exam each worth 50%. You need 9.5 to positively finish the course. Everything you need under www.annaboleyn.net

Introduction Welfare economics is the normative branch of economics: it is concerned with what is good and what is bad rather than what is. Social choice theory deals with question like: How should we choose among Pareto optimal situations? How do we distinguish among the good? In this course we will talk about both The most important results in welfare economics indicate that competitive market mechanisms are good in the sense that they are Pareto optimal. The most important results in social choice theory are connected with attempts to answer this general question: When is A socially better than B?

Introduction

The First Fundamental Theorem I In The Wealth of Nations, Book IV, Smith wrote: Every individual necessarily labours to render the annual revenue of the society as great as he can. He generally indeed neither intends to promote the public interest, nor knows how much he is promoting it. He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Since Smith wrote long before the modern mathematical language of economics was invented, he never rigorously stated, let alone proved, any version of the First Theorem. That was first done by Lerner (1934), Lange (1942) and Arrow (1951).

The First Fundamental Theorem II The First Theorem can be proved under certain assumptions about the general equilibrium model: all individuals and firms in the economy are price takers, each individual chooses his consumption bundle to maximize his utility subject to his budget constraint, each firm chooses its production vector, or inputoutput vector, to maximize its profits subject to some production constraint, agents are self interested and there are no externalities. The First Theorem establishes that a competitive equilibrium is for the common good. What is it? The traditional definition looks to a measure of total value of goods and services produced in the economy. In Smith, the annual revenue of the society is maximized. In Pigou (1920), following Smith, the free play of self-interest leads to the greatest national dividend.

The First Fundamental Theorem III The modern interpretation of common good typically involves Pareto optimality, rather than maximized gross national product Of course, with this definition there exist many equilibria, as the notion rejects any summation or comparison of utilities. The First Fundamental Theorem of Welfare Economics Assume that all individuals and firms are self-interested price takers. Then a competitive equilibrium is Pareto optimal.

Critiques of the First Theorem I The theorem is an abstraction that ignores the facts. Preferences of consumers are not given, they are created by advertising. The real economy is never in equilibrium, most markets are characterized by excess supply or excess demand. The economy is dynamic, tastes and technology are constantly changing, whereas the model assumes they are fixed. The theorem assumes competitive behavior, whereas the real world is full of monopoly and market power. The theorem assumes there are no externalities. In fact, if in an exchange economy person ls utility depends on person 2s consumption as well as his own, the theorem does not hold. Pigou and Coase (next lecture) The theorem ignores distribution. Laissez faire may produce a Pareto optimal outcome, but there are many different Pareto optima, and some are fairer than others. The Second Theorem

The Second Fundamental Theorem I There are two approaches to rectifying the distributional inequities of laissez-faire. The first is the command economy approach: a central bureaucracy makes detailed decisions about the consumption decisions of all individuals and production decisions of all producers. The main theoretical problem with the command approach is that it fails to create appropriate incentives for individuals and firms. Empirics: Examples of the Soviet Union, Mao s China and Cuba show that (to put it mildly) centralized economy leaves much to be desired. The second approach to solving distribution problems is to transfer income or purchasing power among individuals, and then to let the market work. The only kind of purchasing power transfer that does not cause incentive-related losses is the lump-sum money transfer.

The Second Fundamental Theorem II Assumptions are even more strict that in the first case. E.g. quasi concavity of of utility functions and convexity of production possibility sets.

The Second Fundamental Theorem II Assumptions are even more strict that in the first case. E.g. quasi concavity of of utility functions and convexity of production possibility sets. The Second Fundamental Theorem of Welfare Economics Assume that all individuals and producers are self-interested price takers. Then almost any Pareto optimal equilibrium can be achieved via the competitive mechanism, provided appropriate lump-sum taxes and transfers are imposed on individuals and firms. One version of the Second Theorem, restricted to a pure production economy, is particularly relevant to an old debate about the feasibility of socialism, see particularly Lange and Taylor (1939) and Lerner (1944). Anti-socialists including Von Mises (1937) argued that informational problems would make it impossible to coordinate production in a socialist economy; while pro-socialists, particularly Lange, argued that those problems could be overcome by a central planning board, which limited its role to merely announcing a price vector. This was called decentralized socialism.

The Second Theorem in Practice We rarely choose between the two extreme approaches. Instead, we choose among alternative tax policies, redistribution schemes, etc. How shall we decide? Lecture on redistribution and SWF The applied welfare economics focuses on some notion of increasing total output in the economy or simply the allocative efficiency. Other reasons for redistribution include insurance, altruism, fairness. Lecture on Redistribution The practical political decision, in a democracy, is normally based on voting. Lecture on Voting

Criticism of the Pareto Crieterion I 1 There can be an infinite number of Paretian Optima Each with a different level of welfare. As pointed out by Pareto himself, there are an infinite number of points at which maxima of individual optimalities are attained. This criterion explains little or nothing as to how it can be determined whether one optimum position is better or worse than another optimum position. If one were to choose the highest peak, it involves interpersonal comparisons. It is therefore not possible to find out the best of the optimum points of welfare. 2 Not possible to judge many policy proposals There are many policy proposals which cannot be judged with the help of this criterion. It does not apply to any policy proposal which benefits some and harm others. According to Baumol, The Pareto criterion works by side stepping the crucial issue of interpersonal comparison and income distribution that is, by dealing only with cases where no one is harmed so that the problem does not arise.

Criticism of the Pareto Crieterion II 3 The Paretian Criterion is not free from value judgements To say that is possible to make every person better off without making any other person worse off is a value judgment in itself. Though Pareto used the method of ordinal measurement of utility, yet he could not present a value free criterion. 4 Pareto evaluates only unambiguous changes in welfare In his efforts to avoid interpersonal comparisons, Pareto evaluates only unambiguous changes in welfare. The Paretian welfare criterion is thus, of little use in making policy recommendations.

Compensation Criteria Kaldor and Hicks I Kaldor-Hicks criterion, is a measure of economic efficiency that captures some of the intuitive appeal of Pareto efficiency, but has less stringent criteria and is hence applicable to more circumstances. The Kaldor Criterion Under Kaldor-Hicks efficiency, an outcome is considered more efficient if a Pareto optimal outcome can be reached by arranging sufficient compensation from those that are made better off to those that are made worse off so that all would end up no worse off than before. Example A transaction creating an externality (e.g. pollution) on a third party, which is not a Pareto improvement, would be a Kaldor improvement if the buyers and sellers are still willing to carry out the transaction even if they have to fully compensate the victims of the pollution.

Compensation Criteria Kaldor and Hicks II An alternative test, proposed by John Hicks was that of bribery by the losers as opposed to compensation by the winners. The Hicks Criterion An allocation would be preferable to another if, given a proposed move from the second to the first, the losers would not be able to bribe the winners into not undertaking the move. If they were willing to give such a bribe and the winners were willing to take it instead of moving to the proposed allocation, then the proposed state would not be superior.

Compensation Criteria Kaldor and Hicks III Any Pareto improvement is a Kaldor Hicks improvement but not the other way around Pareto improvement region on the utility frontier is a proper subset of the Kaldor Hicks improvements set. In easy words: A change in the economy is a Kaldor-Hicks improvement if the winners gains outweigh the losers losses To check whether a change is Kaldor Hicks improving we can either count the gains and losses or look for transfers that would make it a Pareto improvement. Example You and me are neighbors. You want to throw a party; the party would make me 100 Euro worse off, make you 50 Euro better off, and each of your 30 guests 5 Euro better off. Is the party a Pareto improvement? Is it a Kaldor Hicks improvement?

Compensation Criteria Kaldor and Hicks III We distinguish: 1 the strong Kaldor criterion requires any compensations to be a lump-sum transfer between agents and thus, by not allowing production to change as part of the compensation, one is confined to making transfers within a given UPF; 2 the weak Kaldor criterion allows production to change as part of the compensation, and thereby the entire GUPF is available.

Little s Critique and Defense of the Objective Criteria I Little s Critique It seems improbable that so many people would, in England now, be prepared to say that a change, which, for instance, made the rich so much richer that they could (but would not) overcompensate the poor, who were made poorer, would necessarily increase the wealth of the community. (Little, 1950). Defense of the LSE: 1 The first was to agree and make the could into a would, i.e. have the winners actually compensate the losers. This, of course, leads to an improvements of sorts, the practical objection that arises is that once we are at a new allocation, winners are unlikely to surrender any of their gains.

Little s Critique and Defense of the Objective Criteria II 2 The second defense, pursued by Hicks, was that even if the losers do not get compensated in the move, they might still benefit in the long-run if the criteria were followed consistently by society. The underlying assumption, of course, is that at some point, those who lost utility initially will come across a possible move in which they benefit and a society which follows the Kaldorian rule will move to it and thus they will gain in the end. 3 The third (and perhaps best) line of defense is that the Kaldor-Hicks criteria merely lay out what is economically possible and that it is up to policy-makers, on the basis of their own value judgments, to choose which move to make and whether compensation of the losers should be forced. The final decision will require more philosophical, ethical and political considerations to be brought into the story. What might be these philosophical considerations? Here we enter the normative side of things, and return to it during Lecture on Redistribution and SWF