# day11 - PADP 6950: Founda1ons of Policy Analysis Welfare...

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Unformatted text preview: PADP 6950: Founda1ons of Policy Analysis Welfare Angela Fer1g, PhD Pareto Efficiency An alloca1on is Pareto efficient if it is not possible to reallocate the goods in such a way as to make any one person beEer off without making some other person worse off 1 Significance of Pareto Efficiency Pareto efficiency is a minimal standard of efficiency that you would want an economic system to achieve If the economic system does not achieve Pareto efficiency, then it is possible to reallocate goods to improve everyone's u1lity The economic system is either was1ng resources in produc1on or distribu1ng goods among consumers in a way that wastes u1lity Par1al vs. General Eqbm Par,al equilibrium is a type of economic eqbm where the clearance of the market of one good is obtained independently from prices and quan11es in other markets This is what we have been doing up un1l today General equilibrium is a type of eqbm which considers the interac1on of demand and supply in an economy with several markets We will start with an economy of 2 goods and 2 consumers 2 The Edgeworth Box To illustrate Pareto efficient alloca1ons of goods, we can use the Edgeworth Box The Edgeworth Box is a graph that shows all possible alloca1ons of goods in a two-person, two-good economy Assume we have two people (A and B) and two goods (X1 and X2) to allocate among them 2 A and B have ini1al endowments ( 1 , A ) & (1 , B ) A 2 B 1 2 1 2 and will consume bundles (x , x A ) & (x B , x B ) A How to draw the Edgeworth Box Width: A + B 2 2 Height: A + B A's perspec1ve: indifference curves as usual B's perspec1ve: flip indifference curves such that (0,0) is the top, right-hand corner Put on endowment point Draw indifference curves for A and B that cross through this point 1 1 3 The Edgeworth Box Pareto Efficiency and the Edgeworth Box The Pareto efficient alloca1ons are those at which the indifference curves for the two consumers are tangent to each other At points of tangency, the only way you can move one person to a higher indifference curve is by moving the other one to a lower indifference curve If the indifference curves are not tangent to each other, there is space between the two curves. Within this space, there exist alloca1ons where both individuals are on higher indifference curves This means the alloca1on is not Pareto efficient if the indifference curves are not tangent Pareto improvements are possible in this space 4 Welfare Economics Welfare economics is the study of the efficiency of resource alloca1ons that results from alterna1ve economic systems, public choice mechanisms, and policy regimes There are 2 fundamental results from welfare economics: First Welfare Theorem: Every compe11ve equilibrium alloca1on of resources is Pareto efficient Second Welfare Theorem: Any Pareto efficient alloca1on of resources can be reached through a compe11ve market equilibrium Provided that the government has the ability to make "lump sum" transfers of resources between economic agents These welfare theorems mean that Pareto efficient alloca1ons are iden1cal to compe11ve equilibrium alloca1ons. The Invisible Hand The welfare theorems tell us that a decentralized system of perfectly compe11ve markets achieves Pareto efficient resource alloca1ons. Efficiency is reached even though all economic agents act only in their own self-interest, not necessarily the broader interests of society. The self-interested ac1ons of individuals and firms result in market exchanges that maximize the overall welfare of society, "as if guided by an invisible hand" (Adam Smith). No direct government interven1on is required for achieving efficiency. It is enough to just "let the market work." 5 Policy Distor1ons If policy moves the market away from the compe11ve equilibrium, we call this a "policy distor1on" This means that, not only is direct government interven1on unnecessary for achieving efficiency, it is actually harmful to efficiency if markets are perfectly compe11ve. Policy and Pareto Improvements Virtually every policy you can think of has some winners and some losers This means that in most cases, the adop1on of the policy is NOT a Pareto improvement But what if the total gains from the policy outweigh the total losses? The policy then offers a "poten1al Pareto improvement" This is because it would, in theory, be possible for the winners to compensate the losers so that everyone is beEer of as a result Even though such compensa1on rarely takes place, analysts s1ll tend to favor adop1ng policies where the gains are greater than the losses because of the resul1ng increase in total social surplus (CS + PS) 6 Excep1ons Public policy can only create poten1al Pareto improvements when the structure of the market deviates from perfect compe11on or when externali1es exist Externali1es are situa1ons where the ac1ons of economic agents impose costs or benefits on the rest of society that are not priced in market transac1ons (talk about this next 1me) 7 ...
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## This note was uploaded on 01/18/2012 for the course PADP 6950 taught by Professor Fergi during the Spring '11 term at University of Georgia Athens.

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