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ENVIRONMENTAL
ECONOMICS
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III.WELFARE ECONOMICS
] A. What is welfare economics? ] B. What is an efficient allocation of resources? ] C. What assumptions underlay the concept of efficiency? ] D. What relationship is there between efficiency and perfect markets? ] E. What is the relationship between property rights, externalities and transactions costs?
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WELFARE ECONOMICS
] Is that branch of study which endeavors
to formulate propositions by which we
rank alternative economic situations open
to society on a scale of better or worse
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WELFARE ECONOMICS
] “a glorious failure”
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THE CONCLUSIONS OF
THIS SECTION
] Efficiency means that all gains from trade have been exhausted ] There is no such thing as a unique efficient solution ] “Efficient allocation” does not mean good or best. ] Society can prefer an inefficient allocation to an efficient allocation. ] There is no value-free way of determining the correct or best allocation of resources. ] There are institutional arrangements that guarantee an efficient allocation of resources.
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WELFARE ECONOMICS: A
REVIEW
] Economic coordination ] Economy is a system for organizing production of goods and services and their distribution among people, i.e. allocation of scarce resources among possible alternative uses ] Co-ordination of production, consumption, saving and investment decisions, given resource scarcity, technology, needs and desires of citizens, and the system of rights.
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Markets and efficiency
] Demand = quantity of a good a consumer
is willing to buy at given prices (WTP)
] Consumer is trying maximize utility
(Benefit) buys quantity where MU=MB=
Price
] Producer is maximizing profit
] Quantity produced is where MC=P
] Market clearing price where MB=MC=P
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Static Economic Efficiency
in General Equilibrium
] We consider preferences, production technology, resource availability and initial property rights as given. ] Resource allocation to decide what resources (inputs), what goods to produce and who gets? ] An allocation of resources is said to be efficient if it is not possible to make one or more persons better off without making at least one other person worse off. (Pareto efficient) ] Alternatively, an efficient allocation is where all gains from trade have been exhausted. ] A gain one or more persons without anyone else suffering is known as Pareto improvement.
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Pareto Efficiency
] Efficiency in Production \ Is maximum output being produced with given inputs? - (allocation of inputs) ] Efficiency in Consumption \ Given an output combination, is maximum utility being achieved? - (allocation of given output) ] Product Mix efficiency \ Is the configuration of output such that it maximizes utility? (output mix decision)
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Simple Economy
] Consider an economy consisting of 2 people, Sam(A) and Oscar (B), two goods Wool (X) and Wheat (Y), and two inputs Land ( K) and and Labor (L) each of which is available in a fixed quantity (resource constraint) ] Production function \ X = X (Kx^ , Lx^ ) \ Y = X (K Y, L Y) (eq 5.2) ] Utility functions \ U A^ = U A^ (X A, Y A^ ) \ U B^ = U B^ (XB, Y B^ ) (eq 5.1)
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Efficiency and Markets
First Theorem of Welfare Economics
] In a competitive economy, a market equilibrium is Pareto efficient
Second Theorem of Welfare Economics
] In a competitive economy, any Pareto optimum can be achieved by market forces, provided the resources of the economy are appropriately distributed before the market is allowed to operate
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Adam Smith’s Invisible
Hand
] Each individual judging his or her
own welfare means that social
welfare will be maximized.
] That is, there is a set of prices that
will emerge assuming a given income
distribution that will lead to the
maximum of social welfare.
