Welfare and government intervention

1
Chapter 13

• Welfare and government intervention

2
Welfare economics

• The branch of economics dealing with normative
  issues.
• Its purpose is not to describe how the economy
  works
• but to assess how well it works.

3
Equity and efficiency

• Horizontal equity
• the identical treatment of identical people
• Gender or racial discrimination
• Vertical equity
• the different treatment of different people in
  order to reduce the consequences of their innate
  differences
• Progressive taxation or means testing

4
Pareto efficiency

• An allocation is Pareto-efficient for a given set
  of consumer tastes, resources and technology, if
  it is impossible to move to another allocation
  which would make some people better off and
  nobody worse off.
• Example
• Income redistribution through taxes and social
  security benefits
• Not Pareto efficient
• Production possibility frontier
• Pareto efficient

5
Perfect competition and Pareto efficiency

• If every market in the economy is a perfectly
  competitive free market, the resulting
  equilibrium throughout the economy will be
  Pareto-efficient.
• As expressed in Adam Smiths notion of the
  Invisible Hand.

6
EFFICIENCY UNDER PERFECT COMPETITION

• Achieving social efficiency under perfect
  competition
• efficiency in consumption MU P
• efficiency in production P MC
• assumption of no externalities
• social efficiency in goods marketsMSB MSC
• social efficiency in factor marketsMSBf MSCf

7
The interdependence of goods and factor markets
FIRMS (suppliers of goods and services, demanders
of factor services)
HOUSEHOLDS (demanders of goods and
services, suppliers of factor services)
8
The interdependence of goods and factor markets

(1) Consumer demand
9
The interdependence of goods and factor markets
(2) Producer supply

Goods
P
D1 MU1 MSBG1
O
Q

(1) Consumer demand
10
The interdependence of goods and factor markets
(2) Producer supply

Goods
P
S
D1
O
Q
Goods

(1) Consumer demand
11
The interdependence of goods and factor markets
(3) Factor demand
(2) Producer supply


Goods
P
S
P1
D1
O
Q1
Q
Goods

(1) Consumer demand
12
The interdependence of goods and factor markets
(3) Factor demand
(2) Producer supply


Goods
P
P
S
P1
D1 MVPF1 MSBF1
D1
O
O
Q1
Q
Q
Factor services
Goods


(1) Consumer demand
(4) Factor supply
13
The interdependence of goods and factor markets
(3) Factor demand
(2) Producer supply


Factor services
Goods
P
P
S
S
D2 MU2 MSBG2
PF1
P1
D1
D1
QF1
O
O
Q1
Q
Q
Factor services
Goods


(1) Consumer demand
(4) Factor supply
14
The interdependence of goods and factor markets
(3) Factor demand
(2) Producer supply


Factor services
Goods
P
P
S
S
P2
D2 MU2 MSBG2
PF1
P1
D2 MVPF2 MSBF2
D1
D1
O
Q2
QF1
Q1
O
Q
Q
Factor services
Goods


(1) Consumer demand
(4) Factor supply
15
SOCIAL EFFICIENCY

• Private efficiency in goods markets
• in consumptionMUX / MUY (MRS) PX / PY
• in productionMCX / MCY (MRT) PX / PY
• Social efficiency in goods markets
• between consumersMRSa MRSb ... MRSn
• between producersMRTg MRTh ... MRTn
• in exchange (assuming no externalities)social
  MRS social MRT

16
SOCIAL EFFICIENCY

• Social efficiency in factor markets
• in factor demandMPPL / MPPK MSBL / MSBK PL
  / PK
• in factor supplyMCL / MCK MSCL/ MSCK PL /
  PK
• The achievement of general equilibrium
• Pareto optimality

17
Social efficiency under perfect competition
Production possibility curve
Good Y
O
Good X
18
Social efficiency under perfect competition
Social indifference curves
Good Y
I3
I2
Slope MRT
I1
O
Good X
19
Social efficiency under perfect competition
Market price ratio
Good Y
Slope MRS
I3
I2
Slope MRT
I1
O
Good X
20
Social efficiency under perfect competition
Good Y
Slope MRS
I3
Slope PX / PY
I2
Slope MRT
I1
O
Good X
21
Market failure

• Occurs when equilibrium in free unregulated
  markets will fail to achieve an efficient
  allocation.
• Circumstances
• Imperfect competition
• Social priorities (e.g. equity)
• Externalities
• Other missing markets
• future goods, risk, information.

22
A production externality
Suppose DD represents the demand curve for a
product (which we may interpret as
marginal social benefit).
D
Price
MPC is the marginal private cost incurred by the
firm in producing the good (assumed constant
for simplicity).
P
MPC
D
The market clears where MPC DD at price P and
quantity Q.
Q
Quantity
23
A production externality
24
Solution one property right allocation

• Context
• Air pollution
• MB
• marginal benefit to south country from
  polluting activity
• MC
• marginal cost to north country on account of
  polluting activity
• Q
• Optimal extent of activity
• Problem
• Freeriding

MC
MB
Q
25
Solution two green taxes
26
An example congestion costs
Germany
USA
W Germany
Belgium
Sweden
UK
Cars per thousand population
Spain
Energy and Transport in Figures (EC, 2005)
Federal Highway Administration
http//www.fhwa.dot.gov/ohim/qfvehicles.htm
27
Passenger transport in Great Britain (percentage
of passenger kilometres by road)
28
Actual and optimum road usage
Costs and benefits ()
MSB
O
Cars per minute
29
Actual and optimum road usage
MC (private)
Costs and benefits ()
MSB
O
Cars per minute
30
Actual and optimum road usage
MC (private)
Costs and benefits ()
e
a
MSB
O
Cars per minute
31
Actual and optimum road usage
MC (private)
Costs and benefits ()
e
a
MSB
O
Q1
Cars per minute
32
Actual and optimum road usage
MSC
MC (private)
Costs and benefits ()
d
b
e
a
MSB
O
Q1
Q2
Cars per minute
33
Actual and optimum road usage
MSC
MC (private)
Costs and benefits ()
Optimum charge
d
b
e
c
a
MSB
O
Q1
Q2
Cars per minute
34
TRAFFIC CONGESTION AND TRANSPORT POLICIES

• Policy 1 direct provision
• the road solution
• public transport
• Policy 2 regulation and legislation
• restricting car access
• bus and cycle lanes
• no entry to side streets
• pedestrian-only areas
• parking restrictions

35
TRAFFIC CONGESTION AND TRANSPORT POLICIES

• Policy 3 changing market signals
• extending existing taxes
• road pricing
• variable tolls
• supplementary licences
• electronic road pricing
• area schemes
• variable charging
• subsidising alternative means of transport

36
A consumption externality
E.g. neighbours may benefit from a well-kept
garden.
Price
DD(MPB)
Quantity
37
Market for public goods

• Individual demand curves D1 D2
• Total demand obtained by vertical summation
• Socially optimal output Q
• Output if good is privately provided Q
• Person 2 will pay for it, and Person 1 will
  freeride
• P1 gt marginal benefit at Q
• Revelation of preferences
• Voting menu of public good, tax combinations

MC
P1P2
P
D1 D2
P2
P1
D2
D1
Q
Q
38
Solutions

• Public provision
• Private subsidies
• Vouchers

39
Political economy

• Each consumer has single peaked preferences
• If the ideal amount of tax one wants to pay is
  250, then he will always vote for 250 or the
  choice that is closest to it
• It is evident that the society would get whatever
  the median voter wants
• Assumption Each person has one vote.

40
Political economy

• Issue A
• Only Politician 3 will vote in favour
• Issue B
• Only Politician 2 will vote in favour
• If both issues are voted on simultaneously,
  Politicians 2 and 3 will collude to pass it.