Lecture 12 handout - Welfare Analysis and EV and CV

Lecture 12 handout - 1 Pareto E ciency An allocation is called Pareto ine cient if there is an alternative allocation that would make at least one

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1 Pareto E¢ ciency An allocation is called Pareto ine¢ cient if there is an alternative allocation that would make at least one person better o/ without making anyone worse o/. Allocation A is called a Pareto-improvement over (or, Pareto-dominates) Allocation B if at least one person is better o/ in Allocation A than Allocation B and no one is worse o/. Note that not every two allocations can be compared using the &Pareto- improvement criterion.±If some people are better o/ in Allocation A and others are better o/ in Allocation B , then neither is a Pareto improvement over the other. An allocation is called Pareto e¢ cient (or, Pareto optimal) if there is no way to make someone better o/ without making someone else worse o/. (In other words, an allocation is Pareto e¢ cient if there are no Pareto improvements to be made.) The fundamental normative question is: When should a policy be adopted? Virtually all economists and moral philosophers agree that a policy should be adopted if it leads to a Pareto improvement over the status quo. However, it is unusual for a policy to generate a Pareto improvement; most policies have losers as well as winners. What then? Here is a weaker criterion for comparing policies: Allocation A is called a potential Pareto-improvement (or, Kaldor-Hicks improvement) over Allocation B if, in Allocation A , it is possible in principle for the people who are made better o/ to compensate those who are made worse o/ so that the end result is a Pareto-improvement over Allocation B . The &potential-Pareto-improvement criterion±is weaker than the &Pareto- improvement criterion±in the sense that any policy that is a Pareto improve- ment is also a potential Pareto improvement. However, the converse is not true; whenever a policy has losers, it is not a Pareto improvement, even if the winners could compensate the losers to make everyone better o/. by the winners is only &in principle± and may not happen in reality. How- ever, it has a major advantage: for most questions of whether a policy should Since we as a society often must make these decisions, it is very useful to have
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This note was uploaded on 04/07/2012 for the course ECON 3010 at Cornell University (Engineering School).

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Lecture 12 handout - 1 Pareto E ciency An allocation is called Pareto ine cient if there is an alternative allocation that would make at least one

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