Lecture Note 1: Introduction to Welfare

Economics
Part 2B: Paper 1.

Dr. T.S. Aidt

University of Cambridge
Michaelmas 2012
1 Introduction
This lecture note provides a brisk reminder of the basic ideas, results and
concepts of welfare economics. Most of this should be familiar from last
year. The note sets out the details of a baseline model. We shall make
use of various versions of this model to illustrate and discuss many of the
major results about optimal tax policy and social cost benet analysis in
the lectures to come, so it is worthwhile getting familiar with it from the
beginning and with the notation used. The note also contains a detailed
discussion of the three Pareto conditions, of why they may fail, and of the
Principle of Targeting which can be used to guide policy choices in a rst
best world.
2 The Baseline Model: Notation and Assump-
tions
The lectures draw on a (large) number of dierent textbooks and journal
articles, each of which use their own notation and symbols. These should, of

Disclaimer: This note may contain mistakes. If you spot any, please bring them to
my attention.
1
course, be clear from the context. In the lectures (and the associated notes),
I am aiming at using the following notation and terms consistently.
1. Consumers are indexed by / with / = 1. 2. ...H. In some contexts, we
shall look at a representative consumer and the index / can be dropped.
In other contexts, where there are two types of consumers, it can be
useful to index them with letters rather than with numbers, e.g., / = 1
(for poor) or / = 1 (for rich)
2. Firms or producers are indexed by , with , = 1. ...J.
3. Commodities and factors of production are indexed by i = 0. 1... `. In
general, there can be any number of produced goods and any number
of factors of production. We (mostly) consider two special cases:
(a) The one-factor-of-production-many-outputs case: we assume that
there is only one factor of production, labour, and this factor is
given the index 0 and denoted by |
0
, while the produced goods are
then indexed i = 1. ... `.
(b) The two-factors-of-production-two-outputs case: we assume that
there are two factors of production, labour |
0
and capital /, and
two produced outputs (r
1
and r
2
). Capital is always assumed
to be in xed supply and all variables related to capital (e.g., its
price) is indexed by /.
4. Consumption of commodity i by consumer / is denoted by r
h
i
.
5. The supply of labour by consumer / is denoted by |
h
0
and the (total)
supply of capital (if any) is denoted /. The total amount of time avail-
able for work by consumer / is 1
h
0
and the amount of leisure consumed
is then 1
h
0
= 1
h
0
|
h
0
.
6. The output produced of commodity i by rm , is denoted by
j
i
.
7. The consumer prices of the ` commodities are denoted = (
0
.
1
....
N
.
k
)
and the producer prices are denoted j = (j
0
. j
1
....j
N
. j
k
). Consumer
and producer prices may dier if the government levies taxes on the
commodities. We denote the vector of commodity taxes by t = (t
0
. t
1
..... t
N
. t
k
).
If the tax is a unit tax, the relationship between the producer price,
the consumer price, and the tax for a particular good i is t
i
=
i
j
i
.
If the tax is ad valorem, the relationship is
i
= (1 +t
i
)j
i
or t
i
=
q
i
p
i
p
i
.
2
8. Consumers have preferences dened over the ` commodities and labour
supply (leisure forgone) described by the direct utility function
l
h
= l
h
(|
h
0
. r
h
1
. .... r
h
N
). (1)
Utility is increasing in consumption of goods and decreasing in labour
supply. Utility is often assumed to be cardinal.
9. The budget constraint of consumer / is
N
X
i=1

i
r
h
i
= :
h
+
0
|
h
0
. (2)
where :
h
are other sources of (exogenous) income (in particular prots
from ownership of rms) than labour income.
10. For many purposes, we need to use the indirect utility function and the
expenditure function (which should be familiar from last year). The
indirect utility function, \
h
(. :
h
) is simply linking the maximized
utility to consumer prices and income, i.e., is dened as
\
h
(. :
h
) = max
fl
h
0
;x
h
1
;:::;x
h
N
g
l
h
(|
h
0
. r
h
1
. .... r
h
N
)
subject to the budget constraint. The expenditure function is dened
by minimum expenditure, at given consumer prices, needed to obtain
a given level of utility, i.e.,
1
h
(. l
h
) = min
N
X
i=1

i
r
h
i

0
|
h
0
subject to l
h
(|
h
0
. r
h
1
. .... r
h
N
) = l
h
.
11. Production of commodities takes place in the J rms. Each rm is
characterized by a production set. The production set summarizes all
the production possibilities available to it. It is simply a complete list
of how the rm can turn inputs into outputs. The production function
is one particular way to describe the production set in the case in which
each rm only produces one output, but it is often convenient to use the
more general formulation of a production set that takes into account
3
that each rm may produce more than one output. The production
set of rm , is denoted by 1
j
. A feasible production plan is a vector
of outputs
j
= (
j
1
. ..
j
N
) and inputs such as, for example, labour and
capital |
j
0
and /
j
that belongs to the production set.
12. To make this a little less mysterious, we can draw the production set
of a typical rm (so we drop the rm index) for the case with one
input and one output as in Figure 1. The diagram has output (r
1
) on
the -axis and the input of labour (|
0
) on the r-axis but measured as
negative numbers (so the further one moves to the left, the more leisure
is used for the purpose of production of output).
1
The production set
is indicated as the area under the concave curve. The curve itself
denes the set of ecient production plans and can be represented by
a transformation function 1(r
1
. |
0
) = 0. This function picks out all
the ecient production plans. In the case with one output and one
input, we can simply write it as 1(r
1
. |
0
) = r
1
,(|
0
) where , is the
familiar production function that shows the maximum output produced
from given inputs. The transformation function shown in Figure 1 also
depicts the production frontier of the economy showing the maximum
amount of output the typical rm can produce for each level of input.
In the case drawn, the production frontier is concave. This represents
a case with decreasing returns to scale in production. If, on the other
hand, the frontier is linear, then the production technology has constant
returns to scale.
13. Each rm selects a production plan to maximize its prots subject to
its production set (technology). In the two inputs, capital and labour,
many outputs case, prots can be dened as :
j
=
N
P
i=1
j
i

j
i
j
0
|
j
0
j
k
/
j
.
Notice that we calculate prots at producer prices j. The maximized
prot is denoted by :
j
(j) and depends on producer prices. The supply
of rm , of good i = 1. ...` is
J:
j
(j)
Jj
i
=
j
i
(j). (3)
1
We use the convention that inputs are negative numbers and outputs are positive
numbers. We do this because a unit of a commodity (say leisure) which is used for
production (say supplied as labour to a rm) must be subtracted from the total amount
available of that commodity for consumption.
4
and the demand for labour and capital are given by

J:
j
(j)
Jj
0
= |
j
0
(j) (4)

J:
j
(j)
Jj
k
= /
j
(j). (5)
14. An important consideration for many policy questions is whether rms
make prots or not. This partly depends on technology. If the pro-
duction technology has constant returns to scale, then prots must be
zero in a competitive market. However, if, in the short run, there is
decreasing returns to scale or if there is imperfect competition, prots
are positive. In this case, we assume that the prots are distributed
to consumers as income. If we denote the share of prots from rm ,
that consumer / gets by o
h
j
, then we can write :
h
as
J
P
j=1
o
h
j
:
j
(j). The
income of the consumer now depends on the whole vector of producer
prices and, as we shall see, this will play a role for some of the tax
results that we shall discuss.
15. If the government needs to raise revenue 1, then it must levy taxes on
commodities (including labour and other inputs). We need to make a
distinction between two cases. Firstly, if producer prices are xed, then
the government can buy the bundle of inputs it needs at xed prices.
In this case, we can write the revenue requirement as
1 =
n
X
i=0
(
i
j
i
)r
i
(j). (6)
Secondly, if producer prices are not xed, we must specify the revenue
requirement directly in terms of the individual commodities that the
government needs. This is referred to as the revenue vector which is
simply a list of how much of each commodity the government wants for
its purposes and which is, therefore, not available for consumption or
production purposes in the private sector. An example would be that
the government needs labour inputs to produce education. In that
case, we can specify the revenue requirement in units of labour (i.e.,
how many teaching are needed).
5
Exercise 1 What is the dierence between cardinal and ordinal utility?
Exercise 2 Why is it true that
@
j
(p)
@p
0
= |
j
0
(j)?
Exercise 3 If the production technology has constant returns to scale, why
must prots be zero in a competitive market?
3 The Fundamental Welfare Theorems
In the absence of any (distortionary) taxes and market or information im-
perfections, we expect that a competitive equilibrium will naturally emerge
in which a unique set of prices will clear all markets. This is the starting
point for thinking about economic policy. In particular, the two Fundamen-
tal Welfare Theorems are applicable and can be used as a guide to policy. To
discuss the two Theorems, it is useful to consider a special case of the general
model with two commodities, two factors of production and two (types of)
consumers.
3.1 The 2 2 2 model
Consider the following economy:
1. Two outputs or commodities r
1
and r
2
produced with two inputs,
labour |
0
and capital /. The supplies of labour and capital are exoge-
nously given and equal to | and /, respectively. Below you are asked
to work out how things change if labour supply is endogenous.
2. Production of the two commodities take place in two dierent sectors
of the economy where rms specialize in producing one of these goods.
The production technology in each sector is described by standard neo-
classical production functions:
r
1
= 1
1
(|
1
0
. /
1
) (7)
r
2
= 1
2
(|
1
0
. /
2
) (8)
and labour and capital can move freely from sector to sector.
6
3. There are two consumers, / 2 f,1g, with preferences dened over the
two commodities described by the direct utility functions
2
l
h
= l
h
(r
h
1
. r
h
2
). (9)
The consumers budget constraints are

1
r
h
1
+
2
r
h
2
= :
h
. (10)
where :
h
is the (given) income of consumer / and
i
is the consumer
price of commodity i.
4. The resource constraint of the economy is
| = |
1
0
+|
2
0
(11)
/ = /
1
+/
2
. (12)
3.2 The Pareto conditions
We are interested in the conditions that characterize an ecient allocation
of resources in this economy. Loosely speaking, by ecient we mean an
allocation of resources such that it is not possible to nd another allocation
what would make some consumer better o without making someone else
worse o. We are interested in this for two reasons. Firstly, we want to
study how a competitive market economy allocates resources according to
these conditions. Secondly, we need to understand what these conditions
are in order to understand how economic policy might interfere with them
or how policy interventions can help an economy, which for some reason is
unable to achieve the conditions unaided, to reach them.
There are three (types of) necessary conditions that must be satised
for an allocation of resource to be ecient, summarized under the names
of production eciency, consumption eciency and product mix
eciency. The three conditions are stated in terms of marginal rates of
substitution (MRS), marginal rates of technical substitution (MRTS) and
marginal rates of transformation (MRT). These are strictly speaking neg-
ative numbers as they tell us how much of something has to be given up
2
Since we assume that labour is in xed supply, we do not need to include leisure
(labour) in the utility function, as we would do when we consider the case with endogenous
labour supply.
7
to achieve something else. However, it is more convenient and intuitive to
refer to their absolute value, so that MRS, MRTS and MRT are positive
numbers, and I shall do so throughout the lectures and in the notes. More
specically, the three conditions are:
1. Production eciency: The marginal rate of technical substitution (MRTS)
between any two factors of production must be equal in the production
of all commodities:
`11o
x
1
k;l
0
= `11o
x
2
k;l
0
. (13)
2. Consumption eciency: The marginal rate of substitution (MRS) be-
tween any two commodities must be equal for all consumers, i.e.,
`1o
A
x
1
;x
2
= `1o
B
x
1
;x
2
. (14)
3. Product mix eciency: The (equal) marginal rate of substitution be-
tween r
1
and r
2
in consumption must be equal to the marginal rate of
transformation (MRT) between r
1
and r
2
in production:
`1o
A
x
1
;x
2
= `1o
B
x
1
;x
2
= `11
x
1
;x
2
. (15)
Let us start with a discussion of production eciency. Production e-
ciency requires that any given amount of output is produced using the inputs
in such a way that the output of any other commodity is maximized. To see
more clearly what this means, consider the Edgeworth box diagram shown in
Figure 2. The horizontal length of the box represents the amount of labour
available to the economy, while the height of the box represents the amount
of capital. We record the amount of each factor allocated to the production
of r
1
from the lower left-hand corner (labeled C
x
1
) and the the amount allo-
cated to the production of r
2
from the top right-hand corner (labeled C
x
2
).
Any point in the box corresponds to an allocation of inputs between the two
sectors and thus to a particular level of production of r
1
and r
2
. We can
draw an isoquant for sector r
1
, which represents all the combinations of |
0
and / that can produce r
0
1
units of commodity r
1
(dened by the solution
to r
0
1
= 1
1
(|
1
0
. /
1
)). Consider the particular allocation given by point .
This produces r
0
1
units of commodity r
1
. We can draw the isoquant for the
production of commodity r
2
(dened by that particular allocation of inputs)
8
that goes through point . The output associated with this allocation is
then r
0
2
and r
0
1
. It is clear, however, that this is not production ecient: we
can move capital out of and labour into the of production of r
1
in such a
way to keep production at r
0
1
(move down the isoquant labelled r
0
1
) but in
the process of doing so, we increase the amount of commodity r
2
that can
be produced. This process can be continued until we get to point 1 where
the allocation r
0
1
and r
1
2
is production ecient. At point 1, we see that
the slopes of the two isoquants are the same. The (absolute values of the)
slopes represent the marginal rate of technical substitution (`11o), i.e., the
rate at which it is technically possible to replace labour with capital while
keeping output constant in each sector. Accordingly, we see that production
eciency requires that the marginal rates of technical substitution between
any to inputs must be the same across all outputs, i.e.,
`11o
x
1
k;l
0
= `11o
x
2
k;l
0
. (16)
Of course, there are many such allocations dened by the tangency points in
the box diagram. We can plot these in (r
1
. r
2
) space to get what is called the
production eciency frontier. This is shown in Figure 3. The production
eciency frontier shows the combinations of the maximum amounts of the
two commodities that can be produced with the economys scarce resources.
At any point on the frontier, the marginal rates of technical substitution are
equal. Since production eciency will play an important role later on in our
discussion of optimal taxation, it is worthwhile pausing and thinking through
what this really means:
1. If we think of r
1
and r
2
representing two dierent sectors of the econ-
omy (say, manufacturing and agriculture; or traded versus non-traded
goods; or the public versus the private sector), then production e-
ciency requires that the marginal rates of technical substitution must
be the same in the two sectors.
2. The economy must be producing on its production frontier. In the spe-
cial case, where there is only one output, production eciency simply
requires that any given amount of that (one) output produced must be
using the available resources to the fullest extend, i.e., produce at the
boundary of the production set.
The (the absolute value of the) slope of the production eciency frontier
9
is called the marginal rate of transformation (MRT)

dr
2
dr
1
= `11
x
1
;x
2
(17)
and is illustrated in Figure 3.
Let us now consider consumption eciency. The requirement here is sim-
ply that the marginal rate of substitution between any two commodities must
be the same for all consumers. This can be illustrated in the consumption
box diagram shown in Figure 4. This consumption box is superimposed on
the production frontier diagram from Figure 3. Suppose that the economy
is producing a point 1 on the production eciency frontier. This denes
the quantities of r
1
and r
2
available for consumption. We can draw the
indierence curves for the two consumers in the box (for consumer 1 with
reference to C
B
and for consumer with reference to C
A
). Consumption
eciency requires that the available amounts of the two commodities are
divided between the two consumers along the contract curve, where
`1o
A
x
1
;x
2
= `1o
B
x
1
;x
2
. (18)
The reason this is required for eciency is simply that if the condition fails,
then it is possible to reallocate the two commodities between the two con-
sumers in such a way that would make at least one of them better o.
Product mix eciency requires, in addition, that this common marginal
rate of substitution is exactly equal to the marginal rate of transformation in
production represented by the slope of the production eciency frontier at
point 1. This is shown in Figure 5 where point C corresponds to the point
on the contract curve where the marginal rates of substitution for the two
consumers are equal to the marginal rate of transformation in production at
point 1. The reason that this is required from an eciency point of view
can best be seen by supposing that the condition does not hold and that the
consumption allocation is at, say, point 1 instead of at point C. At point
1the marginal of substitution (say, it is 1) is numerically smaller than the
MRT (say, it is 3) at point 1. So we can produce one unit less of r
1
in return
for 3 units of r
2
. Take the one unit of r
1
away from say person and give
him one unit of r
2
so that he is as well o as before (recall that his MRS
is 1 in absolute value at point 1). Give the extra two units of r
2
to person
1 who will be better o from it. Hence, the allocation cannot be ecient if
MRS is not equal to MRT.
10
It should be clear that there exist many allocations of resources which
satisfy the three necessary conditions for an ecient allocation. We can
summarize these by the utility possibility frontier of the economy. This
is constructed from Figure 5 by, rst, xing a point on the production fron-
tier, say, 1, and then recording the utility levels of the two consumers at
the corresponding consumption ecient allocation and plotting them in a
diagram where we have the (ordinal) utility of consumer on the r-axis and
the (ordinal) utility of consumer 1 on the -axis. Pick another point on the
production eciency frontier and repeat the exercise. In this way, we can
trace out the utility possibility frontier shown in Figure 6. It is downwards
sloping, reecting the fact that allocations on the frontier are Pareto ecient.
What if the factors of production are not xed? This is an important case
that plays a key role in much of the discussion about taxation so it is worth
considering briey what happens if labour is variable and its supply is a choice
made by the two consumers. To this end, suppose that there is an endowment
of labor time, 1
0
, which is the same for the two consumers and that 1
0
=
|
h
0
+ 1
h
0
where 1
h
0
is the amount of leisure enjoyed by consumer /. Leisure
generates utility and should thus be counted as a good in the utility function
l
h
(r
h
1
. r
h
2
. |
h
0
) and the budget constraint should be
1
r
h
1
+
2
r
h
2
+
0
1
h
0
=

0
1
0
+:
h
or
1
r
h
1
+
2
r
h
2
=
0
|
h
0
+:
h
. This extension aects the conditions
for consumption and product mix eciency but has no implications for the
conditions for production eciency.
Exercise 4 Show how the conditions for consumption and product mix e-
ciency are aected when labour supply is endogenous and give the new con-
ditions an intuitive interpretation.
Answer: With regard to consumption eciency, then, we now require in
addition to the condition given above that
`1o
A
x
1
;L
0
= `1o
B
x
1
;L
0
(19)
`1o
A
x
2
;L
0
= `1o
B
x
2
;L
0
(20)
i.e., that the marginal rate of substitution between leisure and any other
commodity must be the same for all consumers. The product mix eciency
condition requires that these common marginal rates of substitution are equal
to the respective marginal products of labour (MP) in production of the two
goods, i.e.,
11
`1o
A
x
1
;L
0
= `1o
B
x
1
;L
0
= `1
x
1
l
0
(21)
`1o
A
x
1
;L
0
= `1o
B
x
1
;L
0
= `1
x
2
l
0
. (22)
3.3 The First Welfare Theorem
The First Welfare Theorem says that a competitive equilibrium is necessarily
ecient, i.e., that the allocation of resources satises the three Pareto con-
ditions. The reason for this is simply that consumers and producers face the
same relative prices and that they optimize by equating these relative prices
to the relevant marginal rates. Firstly, rms minimize costs by employing
the two factors of production till the marginal rate of technical substitution
is equal to the relative wage (j
0
) rental rate (j
k
), so
`11o
x
1
l
0
;k
= `11o
x
2
l
0
;k
=
j
0
j
k
. (23)
Secondly, rms maximize prots by equating the marginal cost of production
to the relevant producer prices, i.e.,
`C
x
1
= j
1
(24)
`C
x
2
= j
2
. (25)
Notice that the total cost of employing labour and capital in the production
of the two commodities are
C
x
1
= j
0
|
1
0
+j
k
/
1
(26)
C
x
2
= j
0
|
2
0
+j
k
/
2
. (27)
The dierentials are linked
dC
x
1
= j
0
d|
1
0
+j
k
d/ = dC
x
2
(28)
because an increase in the use of a factor in the production of r
1
means an
equal reduction in the use of that factor in the production of r
2
(d|
1
0
= d|
2
0
etc.). The marginal cost of r
1
(r
2
) can then be written as
dC
x
1
dx
1
(
dC
x
2
dx
2
) so the
relative marginal cost is
`C
x
1
`C
x
2
=
dC
x
1
dx
1
dC
x
2
dx
2
=
dC
x
1
dC
x
2
dr
2
dr
1
= ()
dr
2
dr
1
(29)
12
because
dC
x
1
dC
x
2
= 1. But
dx
2
dx
1
= `11
x
1
;x
2
. It, therefore, follows that at the
competitive equilibrium, it must be the case that
`11
x
1
;x
2
=
j
1
j
2
(30)
since rms maximize prots by producing each good up to the point where
the marginal cost is equal to the producer price.
Thirdly, consumers maximize utility when the marginal rate of substitu-
tion is equal to the relative consumer price of the two commodities (
1
and

2
), i.e.,
`1o
A
x
1
;x
2
= `1o
B
x
1
;x
2
=

1

2
. (31)
When producers and consumers face the same prices, as they do in a compet-
itive equilibrium without any tax (or other) distortions, we get the product
mix eciency condition
`1o
A
x
1
;x
2
= `1o
B
x
1
;x
2
= `11
x
1
;x
2
(32)
since
q
1
q
2
=
p
1
p
2
. Hence, the competitive equilibrium is ecient: it places the
economy on the utility possibility frontier. Of course, we might not from a
social point of view like the particular allocation of utilities achieved; it could
be very equal or it could be extremely unequal. This is where the Second
Welfare Theorem comes into play.
3.4 The Second Welfare Theorem
The Second Welfare Theorem states that any feasible Pareto ecient allo-
cation on the utility possibility frontier can be attained as a competitive
equilibrium by suitable lump sum redistribution of the endowments of cap-
ital an labour. The endowments belong to the two consumers, so we can
write their incomes as
:
A
=
k
/
A
+
0
|
A
(33)
:
B
=
k

/ /
A

+
0
(| |
A
). (34)
Hence, redistribution of the endowments is basically redistributing of income
amongst consumers, but done in a way so that they cannot avoid their tax
liabilities. In other words, it must be done lump sum. The particular com-
petitive equilibrium attained and the corresponding relative prices that clear
13
the markets depend on the location of the endowment point. Suppose we
start with the endowment corresponding to point 1
0
in Figure 7. This in-
duces a particular competitive equilibrium and a corresponding allocation on
the utility possibility frontier (at point 1). Suppose society prefers an equal
distribution of utility at point C. This can be achieved by redistributing the
endowments to point C
0
and then let the market do the rest!
Exercise 5 What if labour supply is endogenous? How does the Second Wel-
fare Theorem work in that case?
4 Social Welfare Functions
The Pareto criterion is clearly insucient to allow the government to decide
between dierent allocations on the utility possibility frontier. By denition
they are all Pareto ecient and any move in one direction or the other from
a given starting point will make some individuals better o at the expense
of others. In order to rank dierent allocations (and thus to determine the
degree to which is it desirable to redistribute endowments through lump sum
taxes and subsidies) the government must trade o the utility gains and
losses associated with any given policy proposal.
The Bergson-Samuelson approach to this is to specify a social welfare
function:
o\1 = \(l
1
. ...l
H
).
The argument of the SWF is the individual utility index of each member
of society (which in turn are functions of the allocation of resources). It
is normally assumed that social welfare is not decreasing in the utility of
any given individual, i.e., that
@W
@U
h
0. It is clear that this approach pre-
supposes that it makes sense to compare the utility gains and loses of dierent
individuals, that is, that utility is interpersonal comparable. What is
perhaps less clear is that it also pre-supposes that individual utility can be
given a cardinal interpretation. Recall that when cardinal utility is used, the
magnitudes of utility dierences are treated as an signicant and meaningful
quantities. On the other hand, ordinal utility captures only ranking and not
the strength of preferences and any positive monotonic transformation of the
utility function used to characterize a given ranking will be an equally good
representation of that ranking.
14
In fact, a Bergson-Samuelson SWF can only produce a unique social
choice if 1) individual utility functions are cardinal and 2) interpersonal
comparable. To prove this consider the following little example. Two in-
dividuals, / 2 f. 1g, live in a society that needs to allocate 4 beers among
them. Individuals prefer more beer to less. Social welfare is maximized at
the allocation {2,2}. Can we nd ordinal individual utility functions such
that social welfare is uniquely maximized at {2,2}? The answer is no. To see
this, let the social welfare function be the sum of individual utilities, i.e.,
o\1 = l
A
(r
A
) +l
B
(r
B
) (35)
where r
h
is the number of beer given to individual /. If social social welfare
is really maximized at f2. 2g, then it must (among other things) be the case
that
l
A
(2) +l
B
(2) l
A
(1) +l
B
(3). (36)
Rewrite this to get
l
A
(2) l
A
(1) l
B
(3) l
B
(2). (37)
Now suppose that utility is ordinal. In that case, we can transform the
utility function in any way we like as long as the transformation is positive
monotonic. So, let us scale up the utility function of individual 1 by a
constant ` (we are free to do so without scale the utility of individual ).
Then we get
l
A
(2) l
A
(1) `

l
B
(3) l
B
(2)

. (38)
If f2. 2g is the social maximum and utility if ordinal, then this must hold for
any value of ` we might pick. But clearly, since the left-hand side is inde-
pendent of ` and

l
B
(3) l
B
(2)

0, we can always nd a value of ` big

enough to invalidate the inequality. Thus, ordinal utility information is not
sucient for a Bergson-Samuelson SWF to work. Utility must be cardinal.
This is a strong assumption and it should be borne in mind whenever the
Bergson-Samuelson approach is adopted.
Exercise 6 An alternative to the Bergson-Samuelson approach is the Ar-
row approach. Arrows impossibility theorem, however, tells us that under
reasonable assumptions (do you recall from last year what they are?) it is
not possible to dene a transitive social welfare function. How can the two
approaches be reconciled?
15
The choice of social welfare function involves an ethical judgement about
the extent to which welfare gains and losses of dierent individuals can be
traded o. In other words, the choice embodies a statement about the soci-
etys aversion to inequality, about its inequality aversion. The two most
commonly used social welfare functions are the utilitarian and the Rawlsian
SWF. The utilitarian SWF takes the form
o\1 =
P
h
,
h
l
h
. (39)
It is simply the sum of the utilities of all individuals where individuals are
given a social welfare weight ,
h
0. A special case is when all individuals
are given the same weight ,
h
= 1. In this case, the utility of one individual is
a perfect substitute for that of another and the social indierence curves are
straight lines with slope 1. A Rawlsian SWF is concerned with the welfare
of the worst o individual in society. We can express this as follows:
o\1 = min

l
1
. .... l
H

(40)
and we note that the utility of one individual is a perfect complement to
that of another. Consequently, the social indierence curves are Lshaped
with the "kink" located at an allocation with equal utility to everybody. It
is clear that the Rawlsian approach supposes an extremely high degree of
inequality aversion. The utilitarian approach, on the other hand, is much
less equalitarian. Some examples of social choices on the utility possibility
frontier are shown in Figure 8.
Exercise 7 Consider a society with two individuals, and 1. The society
needs to divide one unit of a good between the two. Utility is increasing in the
amount of the good received but at a diminishing rate. The utility function
of individual is equal to l
A
= jl
B
with j 1. Consider and compare the
case with a Rawlsian and a utilitarian SWF when answering the following
questions. How should the unit of the good be divided a) if j = 1 and b)
j 1?
5 The role of the government in a "perfect
world"
We can think of the situation described above as a perfect world. In
such a world, the rst best is attained without any intervention from the
16
government. The rst best is dened as an allocation of resources such
that all Pareto conditions are satised and in which the only constraints
on the economy are those irreducible ones associated with technology and
endowments. The utility frontier shown in Figure 6 is for this reason called
the rst best utility frontier.
The only eciency-related task of the government in a perfect world is to
ensure that markets are competitive and property rights etc. are protected.
Moreover, any redistribution that might be desired can be done without
interfering with eciency simply by an appropriate lump sum reallocation of
endowments. We have perfect separation between eciency and equity.
What is needed for the world to be perfect? Well, we need the conditions
for the two Fundamental Welfare Theorems to apply, which are:
3
1. Perfect competition and price taking behavior in all markets.
2. Complete set of markets (or the absence of externalities and public
goods).
3. Complete and symmetric information.
Whenever one or more of these conditions fail, the world in no longer
perfect and the potential role of government widens and becomes more com-
plicated. Firstly, the government can take it upon itself to (try to) restore
eciency whenever one or more of the three Pareto conditions fail without
government intervention. This may involve regulating monopolies, providing
public goods, or controlling externalities etc. Secondly, redistribution be-
comes more challenging. When information is asymmetric, the sort of lump
sum taxes envisaged by the Second Welfare Theorem becomes impossible. As
a consequence, any attempt to redistribute resources will have eciency im-
plications and the separation between the eciency and redistributive role of
government brakes down. Any redistribution of resources will have to trade-
o the benets in terms of satisfying equity objectives with the eciency
cost.
5.1 First best versus Second best
It matters, however, a great deal how imperfect we think the world is. We
make a distinction between what we might call a rst best and a second best
3
The Second Welfare Theorem also requires convexity.
17
world.
1. A rst best world is one in which the government has the capacity
to correct all market failures and therefore ensure that all the Pareto
conditions are satised. Example: Think about a polluting monopoly.
Here there are two market failures, an externality and a monopoly. If
the government can regulate both pollution and the monopoly, then all
Pareto conditions can be satised and the rst best restored.
2. A second best world is one in which the government only has the ca-
pacity to correct some market failures and, therefore, cannot ensure
that all the Pareto conditions are satised. Another way to put this is
that the economy is characterized by some important failures that the
government simply cannot remove. Example: Think, again, about the
polluting monopoly. If the government cannot regulate pollution, and
only got the power to deal with the monopoly, it will not be possible
to restore all Pareto conditions, and the design of government policy
becomes second best.
6 Distortions
It is useful to make a distinction between two types or classes of distortions
that might cause one or more of the Pareto conditions to fail. The two main
types are:
1. Endogenous distortions. These distortions arise because of market im-
perfections. Examples include natural monopoly, externalities in pro-
duction and consumption, monopoly power in international trade, and
information asymmetries. It is useful to list how these endogenous
distortions can aect the three Pareto conditions:
(a) Product mix ineciencies may arise from 1) the presence of a pro-
duction externality (where the marginal rate of transformation is
dierent from the marginal rate of substitution because market
prices do not reect the damage that production does to con-
sumers); 2) a natural monopoly that produces at a point where
price is above marginal cost which means that the MRT is dierent
from MRS.
18
(b) Production ineciencies may arise from wage dierentials for a
factor between two sectors, e.g., the public and the private sector,
and be associated with dual labour markets or unionization. This
implies that the MRTS is not the same in the two sectors because
producers do not face the same prices.
(c) Consumption ineciencies may arise because of a consumption
externality, such a envy between consumers. This will put a wedge
between market prices and the MRS for dierent consumers.
2. Policy-imposed distortions. Policy-imposed distortions refer to distor-
tions originating from policy choices made by the government that
cause one or more of the Pareto conditions (which would otherwise
have be satised) to fail. Examples include taxes and subsidies, taris,
regulation of entry, public production of goods etc. Again, we can list
some examples of how the Pareto conditions might break down due to
policy-imposed distortions:
(a) Product mix eciency breaks down as soon as the government
introduces a commodity tax since producers and consumers are
not facing the same prices anyone and so MRS and MRT will be
dierent.
(b) Production ineciencies can be created by a set of sector-specic
factor taxes or subsidies. These implies that producers in dierent
sector do not face the same relative input prices. Another example
is the pricing policy in the public sector which may be such that
the price of inputs purchased by the public sector is dierent from
the going market rate in the private sector.
(c) Consumption ineciencies can be imposed if dierent consumers
face dierent relative prices. This happens often in the choice
between consumption and leisure where the after-tax real wage
can dier between otherwise similar people if the tax system allows
for dierential taxation because of marriage status or the number
of children etc. This creates a gap between the MRS of dierent
individuals.
19
7 The Principle of Targeting
In a rst best world, the policy advise to the government is clear: since it can
restore all the failing Pareto conditions, this is exactly what it should do. End
of story. Yet, the question remains, how should it do it? Bhagwati (1971)
suggests a simple principle which we shall call the Principle of Targeting.
It runs like this: if you want to correct a distortion (whether endogenous
or policy-imposed) in a rst best world where you (well, your government)
can, in fact, restore all the (failing) Pareto conditions, you should use the
instrument that directly osets the source of the distortion. You should
target your instrument at the source of the problem.
The point in that there often are many ways to eliminate a particular
distortion (regulate a monopoly, internalize an externality, provide a public
good) and you want to make sure you do it in a way that does not create any
new distortions which, in turn, will create new deviations from the Pareto
conditions somewhere else in the economy. A good example to illustrate this
logic is to consider a simple production externality and the choice between an
externality tax and a green tax. An externality tax (also called a Pigouvian
tax) is levied directly on the externality. A green tax, in contrast, is levied
on the output of the good the production of which is causing the externality.
To be specic, suppose that production of a good
i
sold in a competitive
market at price j
i
generates emission of pollution c
i
. This emission causes
damage to consumers and we denote the social marginal damage thus created
by SMD and suppose that it is increasing in the amount of emission. It is
costly for the rm to control emission, so an extra unit of emission generates
a marginal benet (in terms of cost savings on control) which we denote
`1. The supply of good
i
(j
i
. c
i
) represents the marginal cost of producing
output and is increasing in the producer price for a given amount of emission
of pollution. The situation is illustrated in Figure 9 where the left-hand
diagram shows the amount of emission and the associated `1 and o`1
curves and the right-hand diagram shows the market for
i
with an upwards
sloping supply curve and a horizontal demand curve. Without intervention,
the rms pollution up to the point where the marginal private benet is zero
at c

i
. This is inecient from a social point of view. A tax equal to social
marginal damage, t = o`1, would restore eciency and induce the rm
to control pollution till emission is reduced to c

i
(where SMD=MB). This
is the targeted instrument. Suppose now that the government instead wants
to control pollution by taxing the output of
i
by levying a green tax. In the
20
left-hand panel an increase in the output (green) tax shifts the `1
i
curve
down because the reduction in output reduces the marginal protability of
emission. As a consequences, emission is reduced below c

i
. In the right-hand
panel, the demand curve shifts down (if the tax is collected from consumers).
The reduction in output creates a deadweight loss. For a small output tax
the (marginal) deadweight cost is small while the (net) environmental benet
is large, so welfare can be improved by increasing the tax. At some point,
the marginal deadweight cost in the product market is equal to the marginal
(net) environmental benet and it does not pay to increase the output tax
more. This happens at c
SB
i
2 (c

i
. c

i
). The point to notice, however, is
that the green tax can be used to x the pollution problem but in doing
so, it distorts the choice between
i
and other goods thus imposing a new
ineciency on the economy. The Pigouvian tax avoids this by aiming directly
at the source of the problem and is, therefore, the preferred instrument.
8 Literature
References
[1] Stiglitz, chapters 3 to 5.
[2] Cullis and Jones, chapter 1;
[3] Mueller, chapter 23.1;
[4] Hindriks and Myles, chapters 1 and 12 (sections 7 to 10);
[5] Bhagwati, J.,N. 1971. The Generalized Theory of Distortions and Wel-
fare. In: Bhagwati et al. (eds.) Trade, Balance of Payments and Growth.
North-Holland Publishing [on reserve in the Marshall Library].
21
labour (l
0
)
O
u
t
p
u
t

o
f

x
1

Production frontier
Production set
Figure 1: The production frontier and production set.
1
x
O
2
x
O
Labour
C
a
p
i
t
a
l

0
1
x
A
0
2
x
1
2
x
B
Figure 2: Production Efficiency
Contract
curve
Isoquants
x
1
x
2
Production inefficient
allocations
Production efficient allocations
Figure 3: The production frontier
Production efficiency
frontier
MRT
x
1
x
2
Production efficiency
frontier
E
O
B
Contract curve
Indifference curves for consumer A
Indifference curves
for consumer B
Figure 4: Consumption efficiency.
O
A
x
1
x
2
Production efficiency
frontier
E
O
B
Contract curve
Figure 5: Product mix efficiency.
O
A
same slope
C
D
) (C U
B
) (C U
A
U
A
U
B
) (C U
B
) (C U
A
C
Figure 6: The utility possibility frontier
The utility possibility frontier
x
1
x
2
Production efficiency
frontier
E
O
B
Contract curve
Figure 7: The Second Welfare Theorem.
O
A
Budget
line
C
D
) (C U
B
) (C U
A
Endowment
point after
lump sum tax
Initial endowment
C
D
U
A
U
B
D
C
Rawls
B
U
A
U
Utilitarian
Figure 8: Social choices with Utilitarian and Rawlsian SWFs
' i
MB
' i
e
*
i
e
' i
SMD
) 0 (
'
t MB
i
' i
SMD
i
p
*
p
i
y
Dead weight
loss
* *
i
e
) , (
SB
i i
e p y
*
i
y
* *
i
y
A
t
=>
y
=>
e
t p
*
SB
i
e
) 0 (
'
t MB
i
Figure 9: The principle of targeting