Lecture18Welfare - Introduction to Microeconomics Lecture...

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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 south-east in the area bounded by the indifference curves. Allocation Y is Pareto efficient. X Y The contract curve gives the set of Pareto-efficient 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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2 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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Lecture18Welfare - Introduction to Microeconomics Lecture...

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