Chapter 2: Fundamentals of Welfare Economics - PowerPoint PPT Presentation

Loading...

PPT – Chapter 2: Fundamentals of Welfare Economics PowerPoint presentation | free to download - id: 5d8bb4-NDQyM



Loading


The Adobe Flash plugin is needed to view this content

Get the plugin now

View by Category
About This Presentation
Title:

Chapter 2: Fundamentals of Welfare Economics

Description:

Chapter 2: Fundamentals of Welfare Economics-In order to evaluate government policies, we need a starting point-Welfare Economics the branch of economic theory ... – PowerPoint PPT presentation

Number of Views:95
Avg rating:3.0/5.0
Slides: 42
Provided by: LornePr
Learn more at: http://www.ualberta.ca
Category:

less

Write a Comment
User Comments (0)
Transcript and Presenter's Notes

Title: Chapter 2: Fundamentals of Welfare Economics


1
Chapter 2 Fundamentals of Welfare Economics
  • -In order to evaluate government policies, we
    need a starting point
  • -Welfare Economics the branch of economic
    theory concerned with the social desirability of
    alternate economic states and policies

2
Chapter 2 Fundamentals of Welfare Economics
  • Welfare Economics
  • First Fundamental Theorem of Welfare Economics
  • Second Fundamental Theorem of Welfare Economics

3
Theory - Starting Point Pure Exchange Economy
  • We start with a simple model
  • 2 people
  • 2 goods, each of fixed quantity
  • Determine good allocation
  • The important results of this simple, 2-person
    model hold in more real-world cases of many
    people and many commodities

4
Pure Exchange Economy Example
  • Two people Maka and Susan
  • Two goods Food (f) Video Games (V)
  • We put Maka on the origin, with the y-axis
    representing food and the x axis representing
    video games
  • If we connect a flipped graph of Susans goods,
    we get an EDGEWORTH BOX, where y is all the food
    available and x is all the video games

5
Makas Goods Graph
Ou is Makas food, and Ox is Makas Video Games
u
Food
O
x
Video Games
Maka
6
Edgeworth Box
Susan
y
O
Ow is Susans food, and Oy is Susans Video
Games
r
Total food in the market is Or(Os) and total
Video Games is Os (Or)
u
Food
w
Each point in the Edgeworth Box represents one
possible good allocation
O
s
x
Video Games
Maka
7
Edgeworth and utility
  • We can then add INDIFFERENCE curves to Makas
    graph (each curve indicating all combinations of
    goods with the same utility)
  • Curves farther from O have a greater utility
  • (For a review of indifference curves, refer to
    Intermediate Microeconomics)
  • We can then superimpose Susans utility curves
  • Curves farther from O have a greater utility

8
Makas Utility Curves
Makas utility is greatest at M3
Food
M3
M2
M1
O
Video Games
Maka
9
Edgeworth Box and Utility
Susan
O
Susan has the highest utility at S3
r
S1
A
S2
At point A, Maka has utility of M3 and Susan has
Utility of S2
S3
Food
M3
M2
M1
O
s
Video Games
Maka
10
Edgeworth Box and Utility
Susan
O
If consumption is at A, Maka has utility M1 while
Susan has utility S3
r
A
B
S3
By moving to point B and then point C, Makas
utility increases while Susans remains constant
C
Food
M3
M2
M1
O
s
Video Games
Maka
11
Pareto Efficiency
Susan
O
Point C, where the indifference curves barely
touch is called PARETO EFFICIENT, as one person
cant be made better off without harming the
other.
r
S3
C
Food
M3
M2
M1
O
s
Video Games
Maka
12
Pareto Efficiency
  • When an allocation is NOT pareto efficient, it is
    wasteful (at least one person could be made
    better off)
  • Pareto efficiency evaluates the desirability of
    an allocation
  • A PARETO IMPROVEMENT makes one person better off
    without making anyone else worth off (like the
    move from A to C)
  • However, there may be more than one pareto
    improvement

13
Pareto Efficiency
Susan
O
If we start at point A -C is a pareto
improvement that makes Maka better off -D is a
pareto improvement that makes Susan better off -E
is a pareto improvement that makes both better off
r
A
S3
C
S4
Food
S5
E
M3
M2
D
M1
O
s
Video Games
Maka
14
The Contract Curve
  • Assuming all possible starting points, we can
    find all possible pareto efficient points and
    join them to create a CONTRACT CURVE
  • All along the contract curve, opposing
    indifferent curves are TANGENT to each other
  • Since the slope of the indifference curve is the
    willingness to trade, or MARGINAL RATE OF
    SUBSTITUTION (x for y) (MRSxy), along this
    contract curve

Pareto Efficiency Condition
15
The Contract Curve
Susan
O
r
Food
O
s
Video Games
Maka
16
MATH House and Chase
  • Assume that house and Chase have the following
    utilities and MRS for books and coffee

The Pareto Efficiency Condition therefore becomes
17
MATH House and Chase
  • If there are 10 books, and 4 cups of coffee, then
    the contract curve is expressed as

If House has 6 books, a pareto efficient
allocation would be
18
MATH House and Chase
  • Therefore, House would have 6 books and 2.4 cups
    of coffee, and Chase would have 4 (10-6) books
    and 1.6 (4-2.4) cups of coffee, for utilities of

19
Theory - Starting PointEconomy with production
  • A production economy can be analyzed using the
    PRODUCTION POSSIBILITIES CURVE/FRONTIER
  • The PPC shows all combinations of 2 goods that
    can be produced using available inputs
  • The slope of the PPC shows how much of one good
    must be sacrificed to produce more of the other
    good, or MARGINAL RATE OF TRANSFORMATION (x for
    y) (MRTxy)
  • Note that although the slope is negative, the
    negative is assumed and rarely shown in simple
    calculations

20
Production Possibilities Curve
Here the MRTSpr is equal to (7-5)/(2-1)-2, or
two robots must be given up for an extra pizza.
10
9
8
The marginal cost of the 3rd pizza, or MCp2
robots
7
6
The marginal cost of the 6th and 7th robots, or
MCr1 pizza
Robots
5
4
Therefore, MRTxyMCx/MCy
3
2
Therefore, MRTpr2/12
1
1
2
3
4
5
6
7
8
Pizzas
21
Efficiency and Production
  • If production is possible in an economy, the
    Pareto efficiency condition becomes
  • Assume MRTpr3/4 and MRSpr2/4.
  • -Therefore Maka could get 3 more robots by
    transforming 4 pizzas
  • -BUT Maka only needs to get 2 robots for 4 pizzas
    to maintain utility
  • -Therefore his utility increases from the extra
    robot, Pareto efficiency isnt achieved

22
Efficiency Production Example
  • From the PPC, we know that
  • We can therefore reinterpret Pareto efficiency
    as

23
Theory - First Fundamental Theorem Of Welfare
Economics
  • IF
  • All consumers and producers act as perfect
    competitors (no one has market power)
  • and
  • 2) A market exists for each and every commodity
  • Then
  • Resource allocation is Pareto Efficient

24
First Fundamental Theorem of Welfare Economics
Origins
  • From microeconomic consumer theory, we know that
  • Since prices are the same for all people
  • Therefore economic theory gives us the first part
    of Pareto efficiency

25
First Fundamental Theorem of Welfare Economics
Origins
  • From basic economic theory, a perfect competitive
    firm produces where PMC, therefore
  • But we know that MRT is the ratio of MCs,
    therefore

26
First Fundamental Theorem of Welfare Economics
Origins
  • Again from microeconomic consumer theory, this
    changes to
  • Which satisfies the second requirement of Pareto
    Efficiency
  • Therefore, we can expand Pareto Efficiency to
    imply that

27
Efficiency?Fairness
  • If Pareto Efficiency was the only concern,
    competitive markets automatically achieve it and
    there would be very little need for government
  • Government would exist to protect property rights
  • Laws, Courts, and National Defense
  • But Pareto Efficiency doesnt consider
    distribution. One person could get all societys
    resources while everyone else starves. This
    isnt typically socially optimal.

28
Fairness
Susan
O
r
Points A and B are Pareto efficient, but either
Susan or Maka get almost all societys resources
B
C
Food
A
Many would argue C is better for society, even
though it is not Pareto efficient
O
s
Video Games
Maka
29
Fairness
  • For each utility level of one person, there is a
    maximum utility of the other
  • Graphing each utility against the other gives us
    the UTILITY POSSIBILITIES CURVE
  • Just as typical utility is a function of goods
    consumed Uf(x,y), societal utility can be seen
    as a function of individual utilities Wf(U1,U2)
  • This is referred to as the SOCIAL WELFARE
    FUNCTION, and can produce SOCIAL INDIFFERENCE
    CURVES

30
Utility Possibilities Curve
All points on the curve are Pareto efficient,
while all points below the curve are not. Any
point above the curve is unobtainable
B
Makas Utility
C
A
O
Susans Utility
Maka
31
Typical Social Indifference Curves
An indifference curve farther from the origin
represents a higher level of social welfare.
Makas Utility
O
Susans Utility
Maka
32
Fairness
  • If we superimpose social indifference curves on
    top of the utilities possibilities curve, we can
    find the Pareto efficient point that maximizes
    social welfare
  • This leads us to the SECOND FUNDAMENTAL THEOREM
    OF WELFARE ECONOMICS

33
Maximizing Social Welfare
ii is preferred to i, even though ii is not
Pareto efficient
i
ii
The highest possible social welfare, iii, is
Pareto efficient
Makas Utility
iii
O
Susans Utility
Maka
34
Second Fundamental Theorem of Welfare Economics
  • The SECOND FUNDAMENTAL THEOREM OF WELFARE
    ECONOMICS states that society can attain any
    Pareto efficient allocation of resources by
    making a suitable assignments of original
    endowments, and then letting people trade
  • -Roughly, by redistributing income, society can
    pick the starting point in the Edgeworth box,
    therefore obtaining a desired point on the
    Utility Possibility Frontier

35
Second Fundamental Theorem of Welfare Economics
Susan
O
r
Starting Point
Goal
Food
O
s
Video Games
Maka
36
Why Income Redistribution?
  • Why achieve equity through income redistribution
    instead of taxes/penalties and subsidies/incentive
    s?
  • Taxes and penalties punish income-enhancing
    behavior, encouraging people to work less.
  • Subsidies and incentives give an incentive to
    stay in a negative state to keep receiving
    subsidies and incentives.
  • Lump sum transfers have the least distortion.

37
Why Is Government so Big?
  • Government has to ensure property laws are
    protected. (1st Theorem)
  • Government has to redistribute income to achieve
    equity. (2nd Theorem)
  • Often the assumptions of the First Welfare
    Theorem do not hold (Chapter 3)

38
Welfare Economics Limitations
  • We Assume Government exists to maximize the
    utility of its citizens.
  • Government could aim to Be a global power,
    achieve cultural goals, achieve religious goals,
    etc.
  • Pluswhat if people want to sit on the couch all
    day, watching the Biggest Loser?
  • Should the government support this activity?

39
Merit Goods
  • Merit Good commodities that should be provided
    even if society
  • doesnt want them ie police/fluorine in water
  • And/Or
  • b) is unwilling to cover their cost in the free
    market
  • ie Canadian Broadcast Corporation (CBC)

40
Welfare Economics Evaluation
  • -Welfare Economics is concerned with RESULTS, not
    PROCESS
  • -is the HOW important?
  • -contract law?
  • -Old Testament law?
  • -Lottery?
  • -Free-for-all wrestling match?

41
Welfare Economics Evaluation
  • Welfare Economics asks 3 questions of every
    government action
  • Will it have desirable distributional
    consequences?
  • Will it enhance efficiency?
  • Is the cost reasonable?
  • -Although these questions may be difficult to
    answer, they provide direction, and if they are
    all no, the government shouldnt interfere
About PowerShow.com