Welfare Economics

positive analysis: if 'X' happens under particular

circumstances what are the implications for 'Y'.
normative analysis: what should be done, or how should we
behave in a particular set of circumstances (value
judgement, ethics => welfare economics).
Normative resource and environmental economics is
predominantly founded in utilitarian ethics.
2 broad ethical systems: humanist and naturalist moral
philosophies.
Welfare Economics
naturalist: values derived from humans and non-humans
(resilience of ecosystems)
humanist: anthropological view (only humans have rights
and duties)
libertarian: individual rights and freedom is supreme and
behaviour is assessed in terms of whether or not it
respects those rights/freedoms (i.e., free action)
utilitarian: utility measures individual's pleasure or
happiness (individuals experience pleasure and pain)
aggregation of individual utilities = social welfare
Utilitarianism
founders: David Hume (1711-1776), Jeremy Bentham (1748-
1832), John Stuart Mill (1806-1873)
For utilitarians actions which increase welfare are right and
actions that decrease it are wrong i.e., it is solely the
consequences or outcomes of an action that determine
its moral worth (in contrast, motivists judge actions
according to its motivation).
- The ends might justify the means.
!!!preferences => utility => consumer/producer surpluses!!!
Utility Function

cardinal measure of utility (kg, m, etc.)
ordinal measure of utility (ranking of numbers; 1, 2, 3,..)
with cardinal measuring, interpersonal comparisons are
possible with ordinal measuring are not.
Pareto improvement: a change where at least one person
gains and nobody looses.
Potential Pareto improvement: if gainers could compensate
the losers and still be better off.
( )
1 2
, ,...,
i
U f X X X =
Utility Function
if not cardinal then economists usually do efficiency rather
then welfare analysis, or treat utility functions as if they
were cardinal and do welfare analysis.
Criticisms of consumer sovereignty (preferences):
do people always know what is best for them?
do preferences truly reflect their interests (advertising)?
Amartya Sen (1987), people are both consumers and
citizens. In regard to others, e.g., altruism, Sen
distinguishes between sympathy and commitment.
Sympathy: concerns are reflected in the arguments of
utility function
Commitment: concerns are based on ethical principles
Utility Discounting




and the continuous time version:
0 0 1 1 0 1
1
1, ,
(1 )
W U U and where is the utility discount rate | | | |

= + = =
+
1
0
(1 )
U
W U

= +
+
0
1
(1 )
t
t
t
t
W U

=
=
=
+

0
t
t
t
t
W U e dt

=
=
}
Why Utility Discounting
...some argue that consumers require incentives (e.g., interests) to
exhibit positive time preferences, p > 0.
...others argue that the only ethically defensible position is that
utilities attaching to each generation should be treated equally, p
= 0. Individuals are consumers and citizens (Sen).
...another argument is that there is for every point in time in the
future, a positive probability that the human species will become
extinct, p > 0.
...or considering ethical prescriptions one need to examine their
consequences in varying circumstances (optimal growth models).
Utility and Consumption Discount Rates
U = U(C)
U(C)
C
0 1
( , , , )
t
W f C C C =
Utility as a function of aggregate
consumption
r g q = +
r = consumption discount rate and is not
constant as the utility discount rate is
p = is the utility discount rate
= is the elasticity of the marginal utility of
consumption and
g = is the proportional growth rate of consumption

q
future utility is treated as being worth less than
current utility (1st term)
it is believed that consumption will be higher in
the future (2nd term). So, additional future
consumption is worth less than now (growth in
income and consumption)
What Discount Rates should be used?
Arrow et al. (1996) made a distinction between prescriptive
and descriptive approaches.
for the prescriptive approach we need numbers for
is a purely ethical question
some guesstimation between 1 and 2
some guesstimation of future economic performance
(e.g., the economy grows 4% annually)
for the descriptive approach
there are markets in which individuals' inter-temporal
consumption preferences are revealed
(borrowing/lending) i.e., interest rates. In an ideal world
the rate of interest = individuals' consumption rate of
discount = marginal rate of return on investment.
, , and g q

q
g
Economic Efficiency
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 (applying the
Pareto criterion).
Efficiency in allocation requires that three efficiency
conditions are fulfilled:
- efficiency in consumption,
- efficiency in production, and
- product-mix efficiency.
Efficiency in Consumption
A
0
B
0
B
Ya
A
xa
B
Xb
B
Xa
A
xb
B
Yb
A
Ya
A
Yb
B
X
A
Y
B
Y
A
X
I
A
I
B0
I
B1
a

b

in b the marginal rates of utility substitution are equal; MRUS
A
= MRUS
B
I = indifference
curve
possible allocation
of fixed amounts of
X and Y between
consumers A and B
A Set of Efficient Consumption
Allocations
A
0
B
0
B
X
A
Y
B
Y
A
X
A

C = contract line that links efficient consumption good (X,Y) allocations between A and B consumers

A

A

A

A

A

B

B

B

B

B

B

C

C

Efficiency in Production
X
0
Y
0
K
Ya
L
xa
L
Yb
L
Ya
L
xb
K
Yb
K
Xa
K
Xb
L
Y
K
X
K
Y
L
X
I
X
I
Y0
I
Y1
a

b

in b the marginal rates of technical substitution are equal; MRTS
X
= MRTS
Y
I = isoquant
the possible
allocation of fixed
amounts of inputs
(L and K) to
produce X and Y
consumption
goods
Product-Mix Efficiency
0

Y
a
X

Y

Y
M
I

a

b

in b the marginal rates of transformation are equal: MRT
L
= MRT
K
= MRUS
A
= MRUS
B
c

Y
b
Y
c
X
a
X
b
X
c
if MRUS
A
= MRUS
B
, the slopes
of individuals' indifference
curves are the same => one I.
MRUS = MRT

X
M
Production Possibility Curve/Transformation
Curve using all the available resources
Utility Possibility Frontier (UPF)
0

U
B
Z

a particular allocation of K and L
as between X and Y production
implies particular output levels
for X and Y, and a particular
allocation of these output levels
between A and B corresponds
with a particular level of utility
for A and B.
Suppose all available resources
were used to produce
commodities solely for
consumption by A that maximise
A's utility and vice versa, the
bounded area is then the utility
possibility set
the criterion of economic
efficiency does not provide any
basis for making interpersonal
comparisons

U
A A
R
U
B
R
U
S

R

max
B
U
max
A
U
Maximising Social Welfare
0

U
A
SWC

a

b

SWC = Social Welfare Curve

c

A
a
U
A
b
U
A
c
U
B
a
U
B
b
U
B
c
U
U
B
points along the utility possibility
curve is about making moves
that must involve making one
individual worse off in order to
make the other better off.
A SWF can be used to rank
alternative allocations:

such that welfare is non-
decreasing in U
A
and U
B
previous conditions and the
condition of the equal slopes
between SWC and UPF must
hold


( )
,
A B
W W U U =
Welfare and Efficiency
0

U
A
SWC1

D

E

C

U
B
allocative efficiency is a
necessary condition for
optimality, it is not
generally true that
moving from an
allocation that is not
efficient to one that is
efficient must represent
a welfare improvement.
Judgements about
fairness, or equity, are
embodied in the SWF
analysis, and if accepted
=> optimality is
unambiguously


SWC2

Inter-temporal Welfare Economics
so far we have seen that efficiency and optimality at a point in time
require equality conditions as between various rates of
substitution and transformation (=> given ideal circumstances,
a system of markets could produce an efficient allocation).
Two individuals (A, B) and two time periods (0, 1) with utility
functions:

efficiency requires:
1. equality of individuals' consumption discount rates;
2. equality of rates of return to investment across firms;
3. equality of the common consumption discount rate with the
common rate of return.
0 1
( , )
A A A A
U U C C =
0 1
( , )
B B B B
U U C C =
Alternative Allocation without SWF
a reallocation is desirable if it increases somebody's utility
without reducing anybody else's utility (Pareto efficiency).
Problem:
- for policy analysis, there are a few re-allocations that do
not involve some individuals gaining and some losing.
Therefore, welfare economists use Compensation Tests:
The Kaldor Compensation Test says that an allocation is
superior to one, if the winner could compensate the loser and
still be better off.
The Hicks Compensation Test says that an allocation is
superior to one, if the loser could compensate the winner for
forgoing the move and be no worse off than if the move took
place.
Example: Pareto, Kaldor, and Hicks
efficiency criteria
net-benefits
of John
net-benefits
of Linda
Status quo 100 100
New policy 80 200
Pareto?
Kaldor?
Hicks?
Potential Compensation Tests
The Kaldor-Hicks-Scitovsky test, a reallocation is desirable if:
(i) the winners could compensate the losers and still be better
off, and
(ii) the loser could compensate the winners for the
reallocation not occurring and still be as well off as
they would have been if it did occur.
=> Cost-Benefit Analysis and Environmental Valuation
Compensation tests treat winners and losers equally,
no account is taken of the fairness of the distribution
of well-being