Microeconomics – ECON 1111

UNIT 11 INTRODUCTION TO WELFARE ECONOMICS

Unit Structure

11.0 Overview
11.1 Learning Outcomes
11.2 Equity and Efficiency
11.2.1 Equity
11.2.2 Efficiency
11.3 Perfect Competition and Pareto Efficiency
11.4 Market Failures
11.4.1 Imperfect Competition
11.4.2 Taxation as a Distortion
11.4.3 Externalities
11.4.4 Public Goods
11.4.5 Asymmetric Information
11.5 Key Concepts
11.6 References

11.0 OVERVIEW

Welfare economics deal with the economy theory of measuring and promoting social welfare. It
is the study of how the allocation of resources affects economic well-being. Welfare economics
is associated with two fundamental theorems. The first states that given certain assumptions,
competitive markets produce (Pareto) efficient outcomes; it captures the logic of Adam Smith's
invisible hand. The second states that given further restrictions, any Pareto efficient outcome can
be supported as a competitive market equilibrium. Welfare economics deal with normative issues
such as:
 How well does the economy work?
 What do we mean by well?

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11.1 LEARNING OUTCOMES

By the end of this Unit, you should be able to do the following:

1. Distinguish between Equity and Efficiency.

2. Analyse the relationship of perfect competition and Pareto-Efficiency.
3. Explain the effects of taxation and the theory of Second Best.
4. Describe externalities and the solutions to the problem

11.2 EQUITY AND EFFICIENCY

Consider a pie that should be redistributed among a group of people. The question of efficiency
is whether the pie is as big as possible. The question of equity is whether the pie is divided fairly.
Evaluating equity of a market outcome is much more difficult than evaluating the efficiency.
Whereas efficiency is an objective goal that can be judged on strictly positive ground, equity
involves normative judgements that can go beyond economics and enter into the realm of
political philosophy.

11.2.1 Equity
There are two concepts of equity or ‘fairness’. Horizontal equity calls for identical treatment of
identical people. Vertical equity calls for different treatment of different people to reduce the
consequences of these innate differences. Most people agree that horizontal equity is desirable
(i.e. no discrimination). However, there are different views regarding vertical equity, that is,

 How many resources should be redistributed from rich to poor?

 How to attain positive discrimination?

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11.2.2 Efficiency

Efficiency relates to how fairly resources are allocated to individuals in society. It involves
value judgment because different people have different tastes and priorities. In Welfare
Economics, the concept of Pareto-efficiency has become the standard definition of efficiency.

The Italian economist Vilfredo Pareto (1935) systematically defined the social interest as
efficiency, in which scarce resources are best allocated to competing uses in order to maximize
the net value individuals in society derive from them. A Pareto efficient outcome is one that
cannot be changed so as to make someone better off without also making someone else worse
off. A Pareto improvement is a change that makes at least one person better off without also
making anyone else worse off. Any outcome that we can change to yield a Pareto improvement
is said to be Pareto inefficient.

Your mum tells you that you are inefficient at sweeping the floor. But she is wrong. What she
means is that you are slow and incompetent, and that you leave dust under the tables and chairs.
She is quite correct, but this does not mean you are inefficient. To the contrary, there is no way
for you to do a better job (thereby making your mum happier) without making yourself worse
off. The dust under the tables and chairs, annoying as they are to your mum, are part of a state of
affairs that constitutes a Pareto efficient outcome. Thus, you are an efficient sweeper. Being
efficient is not the same as making society as well off as possible. But this does not make
efficiency an empty concept. To the contrary, it is very powerful. If any current state of affairs is
not Pareto efficient, the policy implication is straightforward: devise a policy to attain a Pareto
improvement.

To illustrate the concept of Pareto - efficiency, we need to consider resource allocation. A

resource allocation is a complete description of who does what and who gets what. Suppose we
want to allocate a good between two individuals namely Bob and Sam (see Figure 11.1).

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Figure 11.1: Resource Allocation

Bob

Sam

Assume the society starts at the initial allocation A, then a movement to B will make both Sam
and Bob better off while a movement to C will make both worst off. 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.

Figure 11.1 shows several possible allocations to Bob and Sam. Starting from the initial
allocation A, several movements are possible. Table 11.1 shows the possible movements in
allocation and its outcome. Two movements are pareto- improvement namely: A to B and A to
G. Implicity allocation A is pareto – inefficient.

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Figure 11.2: Pareto Improvement

Bob
G
B
E

C F

Sam

Table 11.2: Outcomes of Resource Allocation Movements

Movement Outcome
A to B Both Bob and Sam better off
A to C Both Bob and Sam worst off
A to F Sam better off and Bob worst off
A to E Bob better off and Sam worst off
A to G Sam status quo and Bob Better off

Pareto – efficiency and pareto improvements can also be illustrated via production possibility
frontier. Figure 11.3 shows an initial production possibility frontier AB. The frontier AB
illustrates the critical trade-off that arises from the problem of scarcity. Because output is finite
and limited, giving more to Bob means that less is available for Sam to consume, and vice versa.
All the points on the frontier represent Pareto-efficient allocations since a move from one point
to another will invariably make one person better off but only at the expense of the other person.
Suppose the initial allocation is given by point C. A reallocation to point D, for example, will
make Bob better off (because she gets more goods) but Sam worse off (he has a smaller quantity
of goods).

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The diagram clearly illustrates the trade-off between the goals of efficiency and equity. While
all the allocations on frontier AB are Pareto-efficient, they are not equally equitable or fair.
Consider point B where all the goods produced are allocated to Sam so that Bob gets nothing.
While point B is clearly unfair, it is nonetheless efficient since a reallocation up along the
frontier in the direction of point A will make Sam worse off while improving Bob’s welfare.

Figure 11.2: Pareto Efficieny in PPF

Bob
A

Sam

11.3 PERFECT COMPETITION AND EFFCIENCY

A perfectly competitive economy satisfies the three marginal conditions for welfare
maximisation.

Briefly, these conditions are:

1. The marginal rates of substitution between any two commodities must be the same for all
individuals.

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2. The marginal rates of technical substitution between any pair of inputs must be the same
for all producers.
3. The marginal rate of product transformation must equal the marginal rate of substitution
for each pair of goods.

According to the ‘Invisible Hand’ (Adam Smith, 1776): If every market in the economy is a
perfectly competitive free market, the resulting equilibrium throughout the economy will be
Pareto-efficient. This is the cornerstone of welfare economics. Individual firms and consumers,
acting in own self-interest, generate a Pareto efficient general (i.e. economy wide) equilibrium as
if guided to it by a benign invisible hand.

Assume there are many consumers and producers in an economy but only two goods (x and y).
Both markets are free, unregulated and perfectly competitive

In equilibrium:

Price of good x : px = £5
Price of good y : py = £10

Further, labour is the variable factor of production and workers are indifferent as regards the
non-monetary aspects of employment in industry x and industry y and thus, migration of workers
will ensure wages are equalised across all industries.

Stage 1

Recall that p = marginal utility (MU)

Thus, last unit of x produced must yield consumers £5 extra (i.e. marginal) utility; last unit of y
produced must yield consumers £10 extra (i.e. marginal) utility.

Implication; consumers willing to exchange 2 units of x (£10 worth of utility) for 1 unit of y (£10
worth of utility) since such an exchange will not change their total utility (i.e. MRS).

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Stage 2
Each firm produces to the point that p = MC . Thus, marginal cost of the last unit of x produced
must be £5. Marginal cost of the last unit of y produced must be £10.

Stage 3
Migration of workers between industries will ensure that:
wx = wy = w
Stage 4
In equilibrium, =

Stage 5

wx = wy = w; MCx = £5; MCy= £10

= =2 =2

=2

Stage 6
Hence, decreasing the output of good y by 1 unit and transferring the labour thus freed to the
production of good x would increase the output of good x by 2 units.

Feasible resource allocation; society is able to exchange 2 units of good x for one unit of good y.

Stage 7
Consumers willing to exchange two units of good x for one unit of good y; producers able to
exchange two units of good x for one unit of good y.

There is thus no feasible reallocation of resources that can make society better off; Initial
competitive equilibrium in both markets is Pareto efficient.

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Moreover, since workers are paid their marginal product vis:

= .

Then

.
= = = =

MCy = value of good x sacrificed by using last unit of labour to make good y rather than good x.If
industry x is in competitive equilibrium (i.e. px = MUx), then MCy is also the MU that consumers
would have derived from the consumption of good x sacrificed.

First Theorem of Welfare Economics: Competitive equilibrium in all markets generates a Pareto
efficient allocation.

But, there are an infinite number of Pareto efficient allocations; what determines the actual
Pareto efficient outcome?

Second Theorem of Welfare Economics: Any Pareto efficient allocation can be achieved from a
competitive equilibrium with appropriate adjustments to initial endowment.

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11.4 MARKET FAILURES

Market failures are circumstances in which equilibrium in freely competitive unregulated

markets fails to achieve an efficient allocation, i.e. distortions prevent invisible hand from
allocating resources efficiently. There are five main distortions which lead to market failures
namely:

1. Imperfect Competition.
2. Taxation.
3. Externalities.
4. Public goods.
5. Asymmetric Information.

11.4.1 Imperfect Competition

MB = p > MR = MC

Under equilibrium production, consumers are willing to pay more for output at the margin than
it costs firms to produce. Thus, it is Pareto inefficient.

11.4.2 Taxation as a Distortion

Taxation acts as a distortion because it disturbs the equilibrium obtained by equating social
marginal benefit (SMB) and social marginal cost (SMC) of a good. This situation can be
illustrated in Figure 11.3.

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Figure 11.3: Taxation as a Source of Distortion

Price of Films S’S’

SS
E
P1
P0

P2
F

Q1 Q0 Quantity of Films

The market is initially in equilibrium at price P0. Suppose a tax equal to the vertical distance EF
is imposed per unit of films. The supply curve facing producers becomes S’S’. In the new
equilibrium, consumers pay a higher price P1. Thus, at the equilibrium quantity Q1, the marginal
benefit perceived by consumers is P1, but the social marginal cost is P2. This gap between SMB
and SMC means that society would be better off if more films were produced. Hence, the
equilibrium quantity Q1 is socially inefficient.

The main lesson that follows from the above analysis is an echo of the virtues of unfettered
markets: an unregulated competitive market will allocate resources in such a way as to achieve
Pareto-efficiency. Any form of intervention in such market will constitute a distortion that will
reduce social welfare.

But what if a market is not competitive, or is not working efficiently for other reasons? The
Theory of the Second Best says that, in such circumstances, there may be a case for government
intervention to correct the market failure, whatever its source. For example, suppose that there
were a monopoly producer of films. This firm will set price above marginal cost, destroying one
of the key conditions for welfare maximisation. The first-best response of a benevolent

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government should be to force the monopoly to break up. But if that is not possible, the
government can try to discipline the monopoly by imposing a tax on output or on profits.
Similarly, the tax on films distorts production and consumer choice. To minimise the damage,
the government could introduce an equivalent tax on meals, which will restore relative prices.
This suggests that, other things equal, a broad-based value-added tax (i.e., one that applies to all
goods and services indistinctively) is better – from a welfare point of view – than a sales tax that
is imposed selectively.

11.4.3 Externalities

Externalities refer to actions initiated by one party that affect other parties, but for which no
compensation is paid or received. An externality arises whenever an individual’s production or
consumption decision affects the production or consumption of other individuals, other than
through market prices. Externalities can be negative or positive, and they can arise in production
or in consumption. A positive externality is often called an external benefit; a negative
externality is also referred to as an external cost. Suppose your neighbour plays classical music
that you also enjoy. This is a case of an external benefit in consumption. Now imagine a factory
dumping its industrial waste into a river that flows down to a fishing village. Because the
pollution reduces fish catch, the factory creates an external cost for the downstream fishing
community.

Negative Externality in Production

Assume that an aluminium factory emit pollution. For each unit of aluminium produced, a
certain amount of smoke enters the atmosphere. Because this smoke creates a health risk for
those who breathe it the air, it is a negative externality. This externality will affect the efficiency
of market outcome. Because of the externality, the cost of society of producing aluminium is
larger than the cost to the aluminium producers. For each unit of aluminium produced, the social
cost includes the private costs of the aluminium producers plus the costs to those bystanders
adversely affected by the pollution.

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Figure 11.4: Pollution and the Social Optimum

Price of Aluminium Social Cost

Cost of Pollution
Supply Private
Cost

Optimum

Equilibrium

QOPT QEQU Quantity of

Aluminium

Figure 11.4 shows social cost of producing aluminium. The social cost curve is above the supply
curve because it takes into account the external costs imposed on society by aluminium
producers. The difference between these two curves reflects the cost of pollution emitted. In the
presence of a negative externality to production, the social cost of producing aluminium exceeds
the private cost. The optimum quantity of aluminium, QOPT, is therefore smaller than market
equilibrium, QEQU. Since QEQU > QOPT, there is presence of market inefficiency. The reason for
this inefficiency is that the market equilibrium only reflects the private costs of production. In the
market equilibrium, the marginal consumer values aluminium at less than the social cost of
producing it.

The social planner can achieve the optimum level of production by taxing producers of
aluminium for each ton of aluminium produced. The tax would shift the supply curve for
aluminium upward by the size of the tax. If the tax accurately reflected the social cost of smoke
released into the atmosphere, the new supply curve would coincide with the social cost curve. In
the new equilibrium, aluminium producers would produce the socially optimal quantity of
aluminium. Such a tax is said to be internalising the externality because it gives buyers and
sellers in the market am incentive to take account of the external effects of their actions.

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Activity 1

Use a supply and demand diagram to explain the effect of a positive externality in production.

Positive Externalities in Consumption

The analysis of consumption externalities is similar to that of consumption externalities.

Consumption externalities can be positive and negative. The consumption of education yields
positive externalities because a more educated population contribute to a better economic well-
being which benefits everyone. The consumption of alcohol yields to negative externalities if
consumers are more likely to drive under its influence and risk the life of others.

Figure 11.5: Positive Consumption Externality

Supply
Private Cost
Price of Education

Social Value

Demand
Private Value

QEQU QOPT Quantity of Education

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Figure 11.5 shows the case of a positive externality, like that of education. The curve
representing social value is above the demand curve, and the socially optimal quantity, QOPT is
greater than the equilibrium quantity, QEQU. Once again, the government can correct for the
market failure by internalising the externality. To move the market closer to the equilibrium, a
positive externality requires a subsidy. In fact education is heavily subsidised through public
schools and government scholarships. Positive externalities in consumption lead market to
produce a smaller quantity than is socially desirable.

Activity 2

Use a supply and demand diagram to explain the effect of a negative externality in consumption.

11.4.4 Public Goods

Public goods possess some features that make it inherently difficult for the market to provide
such goods. A pure public good is non-excludable and non-rival in consumption. Non-
excludability means that, once provided, the public good automatically becomes available to
anyone who wishes to benefit from it. Non-rivalness means that consumers do not have to
compete for the good since it is available to everybody in the same amount. If one individual
wishes to consume more of the good, it does not mean that less is available for others to
consume. A classic example of a public good is street lighting, which – you can easily check –
satisfies both of the above characteristics par excellence.

Public goods are subject to the problem of free riding. Suppose you wish street lighting to be
provided to your neighbourhood. Will you be willing to contribute to pay for this service?
When you think about it, you realise that, in the event street lighting is provided, you will benefit
whether or not you actually contributed for it. You are probably thinking: why should I pay for
something that I can enjoy even without paying? But everybody is thinking alike; eventually, the

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public good is not provided! The free rider problem is addressed by the government taking
charge of public goods and financing them through taxes.

11.4.5 Asymmetric Information

In contract theory and economics, information asymmetry deals with the study of decisions in
transactions where one party has more or better information than the other.

Information Asymmetry can lead to two main problems:

1. Adverse selection - immoral behaviour that takes advantage of asymmetric information

before a transaction. For example, a person who is not be in optimal health may be more
inclined to purchase life insurance than someone who feels fine.
2. Moral Hazard - immoral behaviour that takes advantage of asymmetric information
after a transaction. For example, if someone has fire insurance they may be more likely to
commit arson to reap the benefits of the insurance.

Activity 3

List the ways that the problem caused by market failures can be solved by government
intervention.

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11.5 KEY CONCEPTS

 Welfare Economics.
 Horizontal and Vertical Equity.
 Pareto Efficiency of Resource Allocations.
 Distortions and Market Failure.
 First-best and Second-best Efficiency.
 Production and Consumption Externalities.
 Public Goods.
 Asymmetric Information.

11.6 REFERENCES

1. Pareto, Vilfredo (1935). The Mind and Society [Trattato Di Sociologia Generale].
Harcourt, Brace.
2. Smith, Adam (1776). Wealth of Nations. W. Strahan and T.Cadell, London. Accessible
at: http://www.bibliomania.com/2/1/65/112/frameset.html

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