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Chapter 20
Slides by Pamela L. Hall
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
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
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
Social-Welfare Function
Using broad definition of social welfare as a level of happiness for society as a whole
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
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
From contract curve in Figure 20.1,we can derive a utility possibilities frontier Theoretically similar in construction to production possibilities frontier 7
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
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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
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
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 20.4 Efficiency in production and exchange for alternative utility levels
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For an economy with production, every utility bundle on this frontier represents a Pareto-efficient allocation
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
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Even after eliminating all Pareto-inefficient allocations, there remains an infinite number of efficient allocations
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
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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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
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
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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
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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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
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
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Egalitarian
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
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Egalitarian
For Robinson and Friday, this criterion sets UR = UF A social-welfare function resulting in equality of utilities is Rawlsian criterion
Maximum level of social welfare given a specific utility possibilities frontier is on Pareto-efficient utility possibilities frontier (Figure 20.6)
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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
Although ethics teaches that virtue is its own reward, classical utilitarian function teaches that reward is its own virtue
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Utilitarian
By incorporating some virtue into classical utilitarian function, we get a generalization of this function
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
The more egalitarian a society is, the more its social indifference curves will approach right angles
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Numerous examples where, due to ordinal preference ranking among individuals, an aggregate ranking is impossible
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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
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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A reasonable social ranking may be stated with the following axioms relating individual consumers preferences
This also holds for the other two pairs (A, C) and (B, C)
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
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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
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
Set of rules governing procedures for social [collective] choice Majority voting satisfies both Pareto Axiom and Nondictatorial Axiom
Treats all agents the same and all agents have just one vote
However, majority rule can lead to a pattern of social choices that is not transitive
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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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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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Majority Voting
Development of a social-welfare function requires more than just an ordinal ranking of individual consumer preferences
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
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
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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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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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
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
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
Public goods
One individuals consumption of a commodity does not decrease ability of another individual
to consume it
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
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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
For example, local zoning ordinances may restrict a firms use of inputs that generate noise, smoke, or odors
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