Welfare Economics

Chapter 20
Slides by Pamela L. Hall

Western Washington University

2005, Southwestern

Introduction

To include societys value of commodities under alternative resource allocations directly involves welfare economics Study of all feasible allocations of resources for a society Establishment of criteria for selecting among these allocations Public Choice Theory Attempts to understand and explain societys actual choice for
resource allocation

Choice is based on normative economics

Involves value judgments Since various agents have conflicting value judgments, it is difficult to establish a socially optimal allocation Even if these differing value judgments prevent a socially optimal allocation Theory of welfare economics provides a method for delineating important conceptual issues facing all societies

Introduction

Aim in this chapter is to investigate how economic theory attempts to reconcile individual decentralized resource allocation with overall social values of a society May be accomplished with a social-welfare function
Requires a cardinal measure of individual consumer preferences

We maximize welfare function subject to a utility possibilities frontier based on individual consumers preferences Then we specify and compare alternative egalitarian social-welfare
functions

We discuss Arrows Impossibility Theorem Indicates that a social-welfare function is impossible given
consumers ordinal ranking of utility and based on some reasonable assumptions concerning societys social rankings

Introduction

Because we cannot determine a social ranking based on individual consumers ordinal preferences

We evaluate idea of majority voting as a second-best Pareto-optimal

allocation

We discuss causes of market failure

Such as monopoly power, externalities, public goods, and asymmetric

information

As potential constraints on improving social welfare We demonstrate Theory of the Second Best by showing how any policy designed for improving social welfare that only corrects some constraints may not result in social welfare improvement

Because economists are unable to specify a social-welfare function, an army

of applied economists is required to develop and direct mechanism designs for filling in economic gaps resulting from missing markets

Objective of each mechanism is to yield an incremental improvement in social

welfare Ttonnement process will move a society toward maximum social welfare

Social-Welfare Function

Using broad definition of social welfare as a level of happiness for society as a whole

Measurement for this happiness is needed to determine socially optimal

allocation of resources

Such a measurement for determining how well off agents are in a society requires
a set of welfare criteria

Much of research on formulation of welfare criteria and their implications for economic policy has relied on Pareto-allocation criterion

A Pareto criterion is a value judgment based on unanimity rule If one agent could be made better off without reducing welfare of others
Social welfare could be improved by allocation that makes this one agent better
off

Since no one agent is made worse off and at least one agent is made better off It is assumed, given independence of utility functions, that all agents would support Pareto criterion

Social-Welfare Function

Pareto-optimal allocation yields an efficient allocation of resources and thus is a necessary condition for a social optimum

However, many decisions on allocation result in an improvement of one

agents utility at expense of other agents

For example, a redistribution of endowments from taxing rich households and

providing subsidized housing for poor households may increase social welfare

But cannot be justified by Pareto criterion

Fundamental inadequacy of Pareto criterion is its inability to yield a complete

ranking of all social states within an economy

Pareto criterion is useless in context of many policy propositions, so additional

welfare criteria are necessary to determine if these policies will improve social welfare

To investigate a social-welfare function, a comparison of individual consumers utilities is generally required

Assumed that utility functions can be measured on a cardinal scale

Under this assumption, taking a monotonic transformation of utility function will
change preference relationships

Pure-exchange Economy

Consider pure-exchange economy developed in Chapter 6 Two-consumer (Friday and Robinson), two-commodity (q1 and q2) economy is illustrated in Figure 20.1 Only points on contract curve can be considered as possible candidates for a social optimum For example, points P1, P2, and P3 represent tangencies of Fridays
and Robinsons indifference curves

Any point off this contract curve is not Pareto efficient

Possible to increase welfare of one consumer without reducing welfare of the other

From contract curve in Figure 20.1,we can derive a utility possibilities frontier Theoretically similar in construction to production possibilities frontier 7

Figure 20.1 Contract curve for a twoconsumer, two-commodity pure-exchange economy

Pure-exchange Economy

Utility possibilities frontier Mapping of Pareto-efficient utilities for Robinson, R, and Friday, F,
corresponding to each point on contract curve For P1, P2, and P3, in Figure 20.1, corresponding utility levels for Robinson and Friday are plotted on horizontal and vertical axes, respectively, in Figure 20.2 Points on utility possibilities frontier correspond to tangency of indifference curves along contract curve in Figure 20.1

Utility combinations associated with P1, P2, and P3 are same for both
figures

Every point inside this utility possibilities frontier is a feasible allocation Corresponding to points inside Edgeworth box of Figure 20.1 Boundary of utility possibilities frontier represents efficiency locus (contract curve) in Figure 20.1

Pure-exchange Economy

For a given amount of q1 and q2, utility possibilities frontier indicates combination of UR and UF that can be obtained An increase in amount of q1 and q2 will result in utility possibilities
frontier shifting outward

With increasing opportunity cost (which yields a concave utility possibilities frontier) Sacrifice in Fridays utility increases for an additional unit increase in
Robinsons utility

However, although a monotonic transformation of an agents utility

function preserves preference ordering

It can result in opportunity cost switching from increasing to decreasing

One basis for assumption of measuring utility on a cardinal scale

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Figure 20.2 Utility possibilities frontier

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Production and Exchange Economy

We can also derive a utility possibilities frontier in a general-equilibrium context by considering production Efficiency condition is based on a given level of utility for Friday

Illustrated in Figure 20.3

Changing this level of utility for Friday will result in alternative combinations of q1 and q2 produced and allocated between Robinson and Friday As illustrated in Figure 20.4, maximizing Robinsons utility given UFas Fridays level of satisfaction results in Pareto-efficient allocation of (qR1, qR2, qF1, qF2) with q*1 and q*2 efficiently produced

With an alternative level of satisfaction for Friday, say UF' maximizing Robins utility

will result in an alternative Pareto-efficient allocation, (qR'1, qR'2, qF'1, qF'2) with q*1 and q*2 produced

In general, considering all possible Pareto-efficient allocations (MRSR = MRSF = MRPT)

We obtain a collection of Pareto-efficient utility levels for both Robinson and Friday
By varying Fridays utility from zero to level where Robinsons utility would be zero Plotting these Pareto-efficient utility combinations yields utility possibilities frontier in Figure
20.2

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Figure 20.3 Efficiency in production and exchange for a two-consumer economy

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Figure 20.4 Efficiency in production and exchange for alternative utility levels

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Production and Exchange Economy

For an economy with production, every utility bundle on this frontier represents a Pareto-efficient allocation

Where MRSR = MRSF and MRSR = MRSF = MRPT

A utility bundle in interior of frontier, say point A, is not Pareto optimal

It is possible to increase either Robinsons or Fridays utility without

decreasing others utility

In contrast, on the frontier, say at point P1, Fridays utility cannot be increased without reducing Robinsons utility

At P1 utility combination and any other utility bundle on frontier are Pareto
optimal

Initial endowment of resources held by Robinson and Friday will determine agents location on frontier

If Robinson has a proportionally larger share of initial resources, utility

bundle P1 may result A reversal of endowments may yield a higher utility level for Friday, such as bundle P3

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Maximizing Social Welfare

Even after eliminating all Pareto-inefficient allocations, there remains an infinite number of efficient allocations

Represented by infinite number of points on utility possibilities frontier

First Fundamental Theorem of Welfare Economics

A perfectly competitive equilibrium will result in a Pareto-efficient allocation Depending on initial distribution of endowments, a perfectly competitive
equilibrium can occur at any point on utility possibilities frontier However, from a societys point of view, allocation resulting from a perfectly competitive equilibrium may not be equitable

Society may redistribute income (initial endowments) among consumers in an

effort to achieve equity

May take form of redistributing income Taxing wealthy and giving tax revenue to poor Providing commodities to poor (for example, Medicare or surplus food from agricultural support programs) Market regulation (for example, rent control or agricultural price supports)

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Maximizing Social Welfare

Efforts by governments to achieve a more equitable allocation are costly in terms of possibly generating inefficiencies within an economy For example, government playing Robin Hood dampens incentive to
work and invest

Often directs resources toward tax avoidance

Can use concept of a social-welfare function as method for determining socially optimal allocation among points on a utility possibilities frontier With a social-welfare function, can determine point that maximizes
social welfare in terms of both equity and efficiency criteria Assuming government is not paternalistic, this function would generally depend on welfare (utility) of agents within an economy

Government would then maximize social welfare subject to utility

possibilities frontier

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Maximizing Social Welfare

For example, consider following social-welfare function, U, for an economy consisting of two consumers (Robinson, R, and Friday, F)

Assuming a diminishing marginal rate of substitution between consumer utilities, we can determine convex social indifference, or isowelfare, curves

Assumption implies that society has inequality aversion

Where (holding social welfare constant) the more satisfaction Robinson has the less society
is willing to give up Fridays utility for one more unit of Robinsons utility

As illustrated in Figure 20.5, tangency between a social indifference curve and utility
possibilities frontier results in maximum level of social welfare

Point P2 is only point on utility possibilities frontier where there is no other point preferred to it

For example, point P3 is Pareto efficient but there are points that are preferred to P3 Even though point A is Pareto inefficient, society prefers it over Pareto-efficient point P3

Using maximum level of social welfare, point P2, we determine optimal allocation of
commodities in Edgeworth box (Figure 20.1) for a pure-exchange economy

Or in production possibilities frontier (Figure 20.3) for a production and exchange economy

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Figure 20.5 Maximizing social welfare

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Shapes of Isowelfare Curves

A social-welfare function represents societys preferences for particular Pareto-efficient points on a utility possibilities frontier Various social preferences may be represented by social indifference
curves taking on various shapes

These shapes (and thus social preferences) are generally based on

some equitable allocation among Pareto-efficient allocations

Comparison of alternative Pareto-efficient points requires value judgments concerning trade-off among consumer utilities Can be no one definition for equity Social indifference curves will take on a number of forms Depending on which criterion (value judgment) is employed for
determining equitable allocation

Two criteriaegalitarian and utilitarian

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Egalitarian

Egalitarianism can take two forms

Allocate each consumer an equal amount of each commodity

In terms of our Robinson and Friday two-commodity economy, this egalitarian criterion sets qR1 = qF1 and qR2 = qF2 In a pure-exchange economy, Robinson and Friday would split total endowment of each commodity in half

Unless Robinson and Friday have identical utility functions, level of utility
achieved by them will not be the same

But their utility levels are not a factor in this egalitarian equity In terms of a social-welfare function, social preferences for Robinsons or Fridays utilities are identical

Are perfect substitutes as long as commodities are allocated equally

between them

Maximizing welfare function with additional constraint that it be Pareto-efficient in

terms of a utility possibilities frontier will result in maximizing social welfare

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Egalitarian

Second type of egalitarian criterion is an allocation of commodities

Resulting in equality of utilities across all consumers

For Robinson and Friday, this criterion sets UR = UF A social-welfare function resulting in equality of utilities is Rawlsian criterion

Most equitable allocation maximizes utility of least-well-off consumer in

society For Robinson and Friday, Rawlsian criterion is

Maximum level of social welfare given a specific utility possibilities frontier is on Pareto-efficient utility possibilities frontier (Figure 20.6)

Unless Robinson and Friday have the same utility functions

Equality of utilities will not result in Robinson and Friday each receiving the same
commodity allocation

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Figure 20.6 Rawlsian socialwelfare function

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Utilitarian

Maximizes sum of consumers utility Criterion was formally developed by Bentham and provided initial impetus to utility theory For Robinson and Friday, criterion is

Called classical utilitarian, or Benthamite welfare function Maximized subject to a utility possibilities frontier (Figure 20.7)

Under utilitarian criterion, increases or decreases in individual consumers utility results in identical changes in social welfare

Only total utility is relevant, so utilitarian criterion does not consider distribution of
utility

As long as social gain is greater than social loss, it makes no difference that consumer who
gains in utility may already be happier than the other consumer

Unless utility functions of individual consumers are close to being identical

Utilitarian criteria can result in substantial differences in consumers utility

Although ethics teaches that virtue is its own reward, classical utilitarian function teaches that reward is its own virtue

Only total level of utility is important

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Figure 20.7 Benthamite (classical utilitarian) social welfare function

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Utilitarian

By incorporating some virtue into classical utilitarian function, we get a generalization of this function

Weighted sum of utilities

Weights (R, F) indicate how important each consumers utility is to overall social
welfare

For example, utility of an individual such as Mother Teresa will be weighted higher than that of a child sex offender

In Figure 20.7, utilitarian social welfare optimal allocation is tangency between social indifference curve and utility possibilities curve

Depending on weights associated with individual consumers utility

Any Pareto-efficient point on utility possibilities frontier could be a social-welfare
maximum

The more egalitarian a society is, the more its social indifference curves will approach right angles

Indicating society is concerned with equity issues of distribution

For a utilitarian society that is indifferent to distribution, curves are more linear

Showing society simply maximizes output

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Arrows Impossibility Theorem

A problem in maximizing social welfare is how to establish this socialwelfare function

A welfare function based on individual consumer preferences would be a

desirable

Assuming social welfare is to reflect some aggregate consumer preferences

However, because preference ranking by consumers is generally only

ordinal

There is not sufficient information to determine a reasonable social preference

ranking of choices

Numerous examples where, due to ordinal preference ranking among individuals, an aggregate ranking is impossible

One example is Battle of the Sexes game discussed in Chapter 14

Couple cannot jointly (socially) rank their preferences for opera or fights

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Arrows Impossibility Theorem

Arrows Impossibility Theorem Impossible to establish a reasonable social preference ranking

based solely on individual ordinal preference rankings

Suppose there are several feasible social states It is assumed each individual in society can ordinally rank these
states as to their desirability To derive a social-welfare function, there must exist a ranking of these states on a society-wide scale that fairly considers these individual preferences

Lets consider just three possible social states (A, B, and C)

For example, these states could be sending a human to Mars, building and equipping a new aircraft carrier, or curing cancer Arrows Impossibility Theorem says a reasonable social ranking of these three states cannot exist based only on how individual agents ordinally rank these states

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Arrows Impossibility Theorem

A reasonable social ranking may be stated with the following axioms relating individual consumers preferences

Axiom 1: CompletenessSocial ranking must rank all social states

Either A > B, B > A, or A B for any two states

Identical to Completeness Axiom for individual preference ordering

Axiom 2: TransitivitySocietys social ranking must be transitive

Given three social states, A, B, and C, if A > B and B > C, then A > C

Identical to Transitivity Axiom for individual preference ordering

Axiom 3: ParetoIf every consumer prefers A to B, then A is preferable in a social

ranking

This also holds for the other two pairs (A, C) and (B, C)

Identical to a Pareto improvement

Axiom 4: NondictatorialOne consumers preferences should not determine

societys preferences

No agent paternalism Axiom 5: Pairwise IndependenceSocietys social ranking between A and B should depend only on individual preferences between A and B Not on individual preferences for some other social state, say state C

Identical to Independence Axiom for individual preference ordering of states of nature

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Arrows Impossibility Theorem

Can now state Arrows Impossibility Theorem more formally A social preference ranking satisfying these five axioms is
impossible, given an ordinal ranking of individual agent preferences

Implies that there is no way to aggregate agents ordinal preferences

into a social preference ranking without relaxing at least one of these axioms

Axioms may seem a reasonable set of conditions for democratically choosing among social states However, Arrow demonstrated that it is impossible to socially choose
among all possible sets of alternatives without violating at least one of the axioms

Thus, social choice must be unreasonable if it is based on agents ordinal preference ranking

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Majority Voting

To see that Arrows Impossibility Theorem holds, lets consider majority voting

Important social preference mechanism design

Set of rules governing procedures for social [collective] choice Majority voting satisfies both Pareto Axiom and Nondictatorial Axiom

Sensitive to each individual agents preferences

Majority voting is symmetric among agents

Treats all agents the same and all agents have just one vote

It is also neutral among alternatives

By not making a distinction among alternatives a priori

However, majority rule can lead to a pattern of social choices that is not transitive

Even though every voter has ordinal and transitive preferences

Thus, it violates Axiom 2

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Majority Voting

Consider ballot in Table 20.1 among three voters, Robinson, Friday, and Simpson Voters preferences are as follows
Robinson and Simpson prefer alternative A to B Robinson and Friday prefer alternative B to C Friday and Simpson prefer alternative C to A

Majority (two) prefers A to B and B to C, but majority also prefers C to A Thus majority voting results in a cyclical pattern that is intransitive Called Condorcet Paradox Presents a major problem for group decision making

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Table 20.1 Condorcet Paradox

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Majority Voting

Next lets consider case in which each voter must vote for just one alternative As illustrated in panel (a) of Table 20.2, ordinal
preference ranking in Table 20.1 results in a three-way tie All three alternatives receive equal votes However, if one alternative is removed, a clear winner results As illustrated in panel (b), when alternative C is removed,
alternative A receives majority vote

Here, Axiom 5 is violated We see this violation of Axiom 5 often in U.S. presidential elections Where a third-party candidate has determined the outcome

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Table 20.2 Pairwise Independence

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Majority Voting

Development of a social-welfare function requires more than just an ordinal ranking of individual consumer preferences

Requires a comparison of utilities across consumers on a cardinal scale

For example, one reason a third party can influence results of an election is that
no weight is given to intensity of voters desires

However, intensity of desires is a utility measure that can only be measured on at least a cardinal scale Magnitude or intensity of an individual voters desires is not known when she votes

However, allowing voters an ordinal preference ranking (Table 20.1) instead of just one vote (Table 20.2) does elicit additional information on voters preference

May result in a social ranking more consistent with a majority of electorate

New voting machines, being put into place after 2000 presidential election, have
capability to allow voters to ordinally rank candidates

Called instantaneous voting, procedure has not yet been widely adopted But offers potential of further revealing voters preferences and mitigating any strategic voting

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Strategic Voting

A problem with allowing ordinal ranking of candidates (or any other choices) is possibility of strategic voting

Where an agent does not reveal her true preferences but instead votes to enhance
outcome in her favor

A game-theory strategy

Particularly effective when number of voters is relatively small or when a strategicvoting coalition can be formed

One form of strategic voting is for an agent, say Friday, to rank her first choice highest

Then rank other alternatives inversely to expected outcome

Thus, Friday would rank alternative expected to be in close competition with her first choice
last, suppressing competitive threat

Strategic voting is illustrated in Table 20.3 for determining social ranking of four alternatives

In panel (a), alternative A, which was not Fridays top choice, comes out on top
However, as illustrated in panel (b), Friday can change outcome by ranking alternative A low
(strategic voting)

Now Fridays top choice, alternative B, comes out on top as the social choice Judges in Olympic games have been accused of practicing this type of strategic voting

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Table 20.3 Strategic Voting

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Strategic Voting

A method for removing this potential of strategic voting is sequential voting Lowest-ranking alternative after each vote is dropped and another
vote is then taken on remaining alternatives

In panel (b) of Table 20.3, alternative C only received a rating of 5 Dropping this alternative from list yields individual preference ranking
for the three alternatives listed in panel (a) of Table 20.4

Now alternative D receives lowest ranking Dropping alternative D and re-voting on alternatives A and B yields
outcome in panel (b)

From panel (b), alternative A is still selected even given strategic voting by Friday

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Table 20.4 Sequential Voting

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Strategic Voting

Sequential voting is used to elect Speaker of the House in U.S. House of Representatives Employing sequential voting also allows for a social ranking of alternatives based on Pairwise Independence Axiom Implementing such a process for U.S. presidential elections would probably have changed a number of outcomes By adopting instantaneous voting, where voters rank their choices
Low-ranking alternatives could be automatically dropped until only two
alternatives are left

Given these two remaining alternatives, a president with majority of support would then be elected

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Strategic Voting

Illustrates that a confederation of individuals forming a society should not be expected to behave with same coherence as would be expected from an individual Arrows Theorem implies that institutional detail and procedures of a
political process (mechanism design) cannot be neglected

Thus, it is not surprising that academic disciplines that complement

economics, such as political science and psychology

Have evolved to address process of group choice Attempt to determine intensities of individual and group desires Formulate policies and rules for group choice and actions

As demonstrated by Condorcet Paradox and quid pro quo example in Chapter 14 An agenda that determines which alternatives are first considered
will affect social choice

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Market Failure

Suppose some process for group decision does exist for determining optimal social choice A naive solution, based on Second Fundamental Theorem of
Welfare Economics

Would advocate allowing markets freedom to obtain this social optimal

given a reallocation of endowments

Unfortunately, this solution is based on properties of a perfectly

competitive equilibrium

Extreme theoretical case of resource allocation

Does not generally hold for any society

When properties of a perfectly-competitive equilibrium do not hold Resulting equilibrium is not efficient, so market failure exists

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Market Failure

In general, conditions causing market failure are classified into four categories

Monopoly power
Exists when one or a number of agents (suppliers or demanders of a commodity) exert some
market power in determining prices

Externalities
An interaction among agents that are not adequately reflected in market priceseffects on
agents are external to market

Air pollution is classic example of an externality

Public goods
One individuals consumption of a commodity does not decrease ability of another individual
to consume it

Examples are national defense, income distribution, and street lights

Asymmetric information
When perfectly competitive assumption of all agents having complete information about
commodities offered in market does not hold

Incomplete information can exist when cost of verifying information about a commodity may not be universal across all buyers and sellers For example, sellers of used automobiles may have information about quality of various automobiles that may be difficult (costly) for potential buyers to acquire

When there is asymmetry in information buyers may purchase a product in excess of a given
quality

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Market Failure

Existence of monopoly power, externalities, public goods, and asymmetric information are justification for establishment of governments to provide mechanisms to address resulting market failures Governments can regulate firms with objectives of mitigating
monopoly power and negative externalities Governments can provide for public goods either by direct production or private incentives Governments can generate information, aid in its dissemination, and mandate that information be provided in an effort to reduce asymmetric information

The more a government must intervene in marketplace to correct these

failures

The less dependent will the economy be on freely operating markets

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Market Failure

In some societies these market failures appear quite large and, thus, freely operating markets are severely limited True in many centrally-planned economies
Where government determines what and how to produce as well
as who should receive commodities produced

Even within U.S., which generally relies on free markets

to allocate resources and outputs, there is always the question concerning level of government intervention For example, many environmental regulations directly limit inputs
firms can use in their production decisions

For example, local zoning ordinances may restrict a firms use of inputs that generate noise, smoke, or odors

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