Social welfare economics foundations for CBA

G. Mason 2010

Under consumption of public good

What examples exist of public goods you care that others under consume? What examples of public goods make no difference that others underconsume?

Social Demand

QA

QB

QC

Q*

Direct and inverse demand

Direct demand views quantity as the dependent variable and price as the independent variable or the driver.
QA = A0 - A1PA

Inverse demand, views price as a marginal utility and measure of the willingness to pay for a specific quantity.
PA = A0 + A1QA

Social welfare rules

Few actions by government make everyone better off; usually there are several winners and several losers. Who are the winners and losers in the following scenarios
Street repairs Subsidies to the arts and culture Mandatory vaccination of girls (under 12) for HPV (see facts sheets)

Pareto Rules 1
Program X improves the welfare of society if it makes at least one person better off without making anyone else worse off. Adler and Posner (reading cited in outline) identify several factors that prevent this rule for working.
Un observability of states of welfare Un comparability of welfare among individuals

Declining marginal utility of money suggests that those who are well off, would be worsened, if many others who are poor are made better off.

Pareto 2
Assume a social preference function (aggregate demand for a public good) given by: U(X1,X2, XN). Also assume H households in a community, and a single road. Cyclists would like a bike path; council must decide. If the bike path is built, the average household will experience utility increase of U. Council has an easy decision if:
Uh > 0 for all households and Uh > 0 for at least one household, or if Uh < 0 for at all one household and (Uh <0 for one household)

Pareto 3
Most situations involve a mix of households that experience increases, neutral or negative utilities from a bike path (Who loses from a bike path?) Nave solution is add utilities
Utot = U1 + U2 +. Uh

Utility is an ordinal measure, not cardinal That means we cannot compare utilities directly

Willingness to Pay
Compensating Variation
Beneficiaries of bike path
What is the maximum amount you are willing to pay to have the bike path constructed?

Opponents of bike path

What is the minimum amount you are willing to accept of the bike path were constructed.

This is a proxy for the change in utility from the perspective of adopting the new. For household h, if compensating variation is CVh >0, then Uh > 0; if CVh <0, then Uh < 0; and if CVh =0, then Uh = 0.

Willingness to Pay
Equivalent Variation
Beneficiaries of bike path
What is the minimum amount you would accept to forgo the bike path?

Opponents of the bike path

What is the maximum amount you would be willing to pay to stop the bike path?

This is the proxy for utility from the perspective of preserving the old. For household h, if equivalent variation is EVh >0, then Uh > 0; if EVh <0, then Uh < 0; and if EVh =0, then Uh = 0.

Beneficiaries Opponents
Compensating Variation Equivalent Variation Move to New Maintain the Old Payment to get project Payment to accept project

Payment Payment to received to forgo prevent bike path project

Several methods exist to measure willingness to pay, including revealed preference (demand studies) and direct surveys. These will be reviewed in more detail, later in the course

First compensation rule

It may be tempting to conduct a survey and then add CVh across all households. If CVh > 0 this is the first compensation test in public policy Issues
To ensure Pareto optimality, those whose welfare declines with the change must actually be compensated. (This raises mechanical issues of getting winners to pay losers). It also causes strategic biases if survey respondents raise price to get more money (ie., overstate their need for compensation) Marginal utility of income means that one can compare CV and EV only for those at the same income.
Key assumption of CBA Government uses tax and transfer policies to ensure an optimal distribution of income, such that the marginal utility of income is equivalent for all.

Second compensation rule

If EVh > 0 this is the second compensation test in public policy (subject to equal marginal utilities of income). This is the preservation scenario. If EV>0, then the minimum amount needed by cyclists to forgo the path, exceeds the maximum amount opponents would be willing to pay to preserve the status quo. This means the project proceeds If EV<0, then the opponents can buy off the beneficiaries and the project does not proceed.

Combining the rules

1.CV> 0, EV > 0 (proceed)
Both compensation rules are satisfied. Winners can compensate losers if the project were build, and losers could not compensate winners if the project were not built. If path does not exist, build it; the path exists retain it.

2.EV<0, CV<0 (do nor proceed)

Those who gain fro the status quo can compensate those who want the project; if the project exists, those that want to cancel it, can compensate those that want to maintain it. If the path does not exist, do not build it; if it exists, destroy it.

3.CV>0, EV<0
If there no path, winners can compensate losers. If there is a path, losers can compensate winners. If there is no path, build it; if a path exists, get rid of it!

4.EV>0, CV<0
EV>0 implies that if there is a path, then destroying it would cause a welfare loss; if CV<0, then if there is no path, constructing it would cause a welfare loss.

The third and fourth situations are the essence of what is called the Scitovsky paradox or Scitovsky reversal If EV and CV are negative reject the project; If EV and CV are positive, adopt the project. Combinations 3 and 4 offer no guidance, and the status quo should be maintained, pending more data.

Consumer surplus
At P1, consumers are willing to buy X1. At smaller quantities, they are prepared to pay more, but not have to. a is the consumer surplus at P1 When prices drop, consumer surplus rises to a+b+c

a P1 b P2 d e c D

X1

X2

Consumer surplus and CV,EV

Normal goods EV>CS>CV Inferior goods EV<CS<CV EV= CS=CV when income elasticity is zero. In general, measures of consumer surplus perform reasonably well in measuring changes in social welfare

Changes due to price of substitutes and complements

Assume that X, Y and Z are three commodities Y is substitute for X and Z is a complement of X. A price decrease in X, reduces demand for Y, and increases the demand for Z

Price of X increases, reduces the demand for Y

Price of X increases, increase the demand for z

Py f g

Pz Dy1
Dy2

Dz2 h i Dz1

y1

y2

z1

z2

Overall income has not changed: Therefore b+d+f+g+h = d+e+f+h+j Rearranging b=eg+j And therefore b+c = (c + e) g +j
Recall that b+c was the increase in consumer surplus from a price reduction in x Refer to previous figure as well for b, c d, and e

Change in undistorted markets

Px

Undistorted means that P = MC

a

P1 b P2 d e Dx c MC

Price of X drops, but demand for the substitute Y falls and increases for the complement

B=c+e-g+j W = B - C

X1

X2

Py

Pz

Py f Dy1 g Dy2 y2 y1

MC Pz
h Dz2 j Dz1

MC

z1

z2

W = [c+e-g+j] [e-g+j], or market by market W = [c+e-e] +[-g+g] + [j-j], x y z

Distorted markets
Pj

P2 k P1 m Dj MCj

The economy has three goods J, K, L. L is a composite good representing all other goods except J and K The price of J rises from P1 to P2. The demand drops for J, but rises for K and L. The price of K is distorted because it is less than its marginal cost.

J2

J1

J, K, and L are assumed to be substitutes when the price of J drops the demand for K and l increases.

Pk

PL

MCk q Pk n

MCk
MCL DL2 DL1 L1 L2

PL

DK2 DK1

K1

K2

In market J, consumers lose k + m In markets K and L, they receive n + r.

B = n + r (k + m)
The resource cost declines for J = m, increases for K (q + n) and L (r) W = B - W = q + n + r - m