Graduate Diploma - Microeconomics E.

Sciubba - Lecture 9

Pareto optimality and market allocation

Recall main result from previous lecture: Pareto optimal allocations are such that indi erence curves are tangent. First fundamental theorem of welfare economics: if markets are competitive, the market allocation is Pareto optimal. Why?

If markets are competitive, individuals take prices as given and choose a bundle such that: marginal rate of substitution = price ratio Given that all individuals face the same prices, then mrs for A = mrs for B Hence at a competitive market equilibrium, the indifference curves for the two individuals are tangent. Decentralised trading (markets) gives us the same solution as bilateral bargaining.

The importance of the First Welfare Theorem is that it gives us a general mechanism - the competitive market - that we can use to ensure Pareto e cient outcomes. If there are only two agents involved, this doesn't matter very much; it is easy for two agents to get together and examine the possibilities for mutually bene cial trades. But if there are thousands of people involved? Very simple informational requirement: we only need to look at the market price for a good.

What if we also care about distribution? Second welfare theorem: every Pareto e cient allocation can be achieved as a competitive equilibrium. We do not need to alter the mechanism. All we need to do is redistribute initial resources and then let prices (the competitive market mechanism) do the job. Idea is the following: suppose that the policy maker would like to implement a particular pareto optimal allocation (i.e. a speci c point on the contract curve). Then, all the policy maker needs to do is to redistribute initial resources and then let the market mechanism operate to ensure that the desired allocation is reached (and to ensure that the allocation that is reached is pareto optimal). Main message from the second welfare theorem is that the problems of distribution and e ciency can be separated.

Prices play two roles in the market system:

an allocative role: they indicate relative scarcity

a distributive role: they determine how much people can a ord

Second welfare theorem says that these two roles can be separated: we can redistribute endowments of goods to determine how much wealth agents have, and then use prices to indicate relative scarcity.

Distortionary versus non-distortionary taxation. Non-distortionary taxation is a form of taxation that does not a ect individual decisions at the margin, i.e. taxation that does not interfere with the price mechanism. The only type of non-distortionary taxation is lump-sum taxation on endowments. What about taxing income? Income is generated by the sale of the labour endowment that we have. Taking income is distortionary because it a ects our incentives to sell labour. If we were taxed on our endowment of labour (how much labour we can potentially sell), this would be non-distortionary. Another example: redistribute resources to the retired elderly by having them pay less on buses. This is distortionary. Welfare loss compared to what one would have if extra money was transfered directly to the elderly and they could then choose what to do with it (not necessarily taking the bus!). Main problem is: How to implement this?

Welfare
Start from the contract curve:
xB1 xA2 0B

xB2 0A xA1

Use a di erent diagram to represent the level of utilities that each of the two individuals achieve at Pareto optimal allocations:

UB

UA

This is the utility possibility frontier. The two intercepts represents the level of utilities that correspond to the two origins of the Edgeworth box. I need to describe social preferences on the way in which utility is distributed. Several possibilities for a social welfare function.

Utilitarian approach: I could give all individuals the same weight

W = UA + UB

and more in general

W =
n X

Ui

i=1

Weighted-sum-of-utilities welfare function:

W =
n X iUi

i=1

Minimax of Rawlsian social welfare function: it is only the individuals with the lowest level of utility that matter
W = minfUA; UB g

If the policy maker is utilitarian, this is the distribu-

tional choice:

UB

UA

If the policy maker is a rawlsian, this is the distributional choice:

UB

UA

Range between the two extremes:

UB

UA

Market Failures
Recall the rst welfare theorem

Are

all

market allocations e cient?

Not, if we do not have competitive markets, but monopoly or oligopoly

What about competitive markets: are petitive market allocations e cient?

all

com-

What if we have asymmetric information? Market failure

Other cases of market failures are:

Externalities

Public Goods

Externalities
Example: pollution. Acid rain is the outcome of the operation of markets. Does this mean that acid rain is e cient? And if not, what role is there for government intervention? Need to distinguish between two ways in which economic agents (consumers and rms) can a ect each other's welfare. Suppose that people become more health conscious and start consuming more breakfast cereals and less croissants. As demand for breakfast cereals increases, the price increases, making breakfast cereals producers better o and decreasing the welfare of people who were already consuming breakfast cereals. As the demand for croissants falls, etc. etc.

By the time the economy settles into a new general equilibrium, the distribution of real income in the economy has changed substantially. People are in uencing each other's welfare! However all of the e ects are transmitted by changes in market prices. Suppose that before the change in preferences, the allocation of resources was Pareto e cient. The shifts in demand change the relative prices. However - as long as consumers maximise utility - the new equilibrium will be such that marginal rates of substitution will be equal to the new price ratio and equal across consumers. The new equilibrium is Pareto e cient. The behavior of some people a ects the welfare of others, but this does not automatically imply ine ciency.

Consider now a di erent example: pollution generated by one factory negatively a ects the welfare of a nearby shery. The decrease of welfare for the shery is not the result of a price change. Rather, the output choices of the nearby factory directly a ects the shery's production. When the activity of one economic agent (consumer or rm) directly a ects the welfare of another in a way that is not transmitted by market prices, that e ect is called an externality, because one entity directly affects the welfare of another entity that is 'external' to it. Unlike e ects that are transmitted through market prices, externalities can adversely a ect economic efciency.

Consumption and production externalities

Positive and negative externalities

Pollution: costs and bene ts The marginal cost of each unit of pollution is equal to the incremental damage done to the shery by that unit. We assume that as the amount of pollution increases, the damage worsens at an increasing rate: the rst few units of pollution do little harm, but when the pollution accumulates, the incremental number of sh killed goes up even faster:

MC

MC

Bene ts? Cost reduction for the factory (or increased production for the factory): the marginal bene t of an extra unit of pollution is the extra output associated with that pollution and/or the cpst savings that the production of pollution allows. We assume that the marginal bene ts to emissions decline with the quantity of emissions. This might be due to the fall in the consumers' marginal valuation of the factory output as the quantity increases.

MC MB MC

MB

P P*

The socially optimal amount of pollution is when M B = M C , at P . Is this the actual level of pollution? Not likely! Damage to the shery is external to the factory. There is no internal cost for pollution that the has to sustain. rm

Factory will continue to pollute until there is no further marginal bene t. Socially desirable level of pollution is P , but market level of pollution is P .

MC MB MC

MB

P P* P

Negative externality results in overproduction Ine ciency is measured by the distance between P and P Ine cient because at P there is a positive marginal cost, but the marginal bene t is zero. Interpretation: there is a missing market: no market for clean air, or for rights to pollute!

A consumption externality: tra c congestion Marginal bene t of taking the car Marginal private cost of taking the car Marginal social cost of taking the car, di erent from the marginal private cost

MC MB

MSC

MPC

MB

D D* D

Example of positive externality: Christmas decorations in a shopping street

MC MB MC

MSB MPB

C C C*

Intervention
Mergers

Regulation

Taxes (or subsidies)

Introduction of a market

Public Goods
A public good is:

non rival in consumption

non excludable

Private goods are to be provided at the point where the (private) marginal bene t equals the marginal cost of provision Public goods are to be provided at the point where the sum of the private marginal bene ts equals the marginal cost of provision Example: neighbourhood watch

MC MB

MBA+MBB

MC MBA MBB W W*

Problem: how to elicit individual preferences over a public good? Problem of free riding.