1
Introduction to
Microeconomics
Lecture 18
Welfare and Externalities
Simon Cowan
Issues
How can we compare different allocations of
resources?
Efficiency and the First Fundamental Theorem of Welfare
Economics
Equity and the Second Fundamental Theorem of Welfare
Economics
Social welfare functions
Externalities and other market failures
Pareto efficiency
An allocation is Pareto efficient if there is no way to
make someone better off without making someone
else worse off
If an allocation is not Pareto efficient then it is
possible to make at least one person better off
without harming anyone
Such a move is a “Pareto improvement”
A minimal requirement for public policy is to ensure
that a Pareto efficient allocation is achieved
The Edgeworth Box and a
Pareto improvement
O
A
Cheese
Dates
O
B
•
The initial allocation at
X
is Pareto inefficient. Both Alice and Bob can be made
better off by an allocation to the southeast in the area bounded by the indifference
curves. Allocation
Y
is Pareto efficient.
X
Y
•
The contract curve gives the set of
Paretoefficient allocations
O
A
O
B
•
Z
Contract curve = set of all Pareto efficient allocations. Indifference
curves are tangential.
Dates
Cheese
•
Y
First Theorem of Welfare
Economics
Any competitive equilibrium is Pareto efficient
Invisible Hand of Adam Smith
Each agent maximizes her/his objective (utility,
profits) selfishly
The result is not chaos but an efficient allocation
Role for government?
Income distribution
Correcting market failures
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Some intuition
Each agent maximizes utility subject to their budget
constraint
So their marginal rates of substitution equal relative
prices
All agents face the same relative prices
So marginal rates of substitution are the same for all
agents
The allocation is on the contract curve and is
efficient
Assumptions for First
Theorem
No externalities
Agents don’t care about what others consume
No pollution
Complete set of markets
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 Spring '10
 Vines
 Economics, Externalities, pareto, Pareto efficient allocations, Pareto efficient allocation

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