INNOCENT MUGANYIZI Email:

ECONOMETRICS II
PANTALEO [email protected]

WELFARE
ECONOMICS

Lecture One

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 i. Pareto Optimality and Competitive Markets

ii. Theorem of Welfare Economics

Roadmap iii. International Considerations

iv. Theory of the Second Best

v. Social Welfare Functions

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 Motivation for studying welfare in
a general equilibrium framework
allocation of
Uses productive
microeco factors
often
nomic relative
technique desirability to
Welfare s to compet
economics evaluate itive
well- economic general
being efficiency equilibr
from within an ium.
economy

The discussion will focus on a Pure exchange economy.

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 Motivation for studying welfare in a
general equilibrium framework
Reducing sugar tariffs reduces
 Previously sugar prices (SUGAR MARKET)
mainly on partial This drops in employment of
equilibrium, i.e: sugar cane farmers (LABOR
MARKET)
one market at a
time: labor, Cane workers apply for other
Markets are
sugar, food, etc. farm jobs, depress wages for
always farm workers generally(LABOR
 However, in real interrelated
MARKET)

world no single Arable land is freed for other

market effects--- uses (LAND or FACTOR
MARKET)
it was just a
fiction Gives rise to new crop
production (NEW CROP
MARKET)

...there is literally no end to this chain of events

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 Motivation for studying welfare in a
general equilibrium framework
Income effects
Thus, General
Equilibrium
All changes in
Substitutability Model can
quantities or prices
/complementari accommodate
ultimately feed ty of goods the interactions
back into the whose prices of all markets
demand and/or rise/fall
simultaneously
supply for all other
and determine
goods through Changes in the the properties
several channels: abundance/scar of the grand
city of
resources
equilibrium.

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 Pareto Optimality and Competitive
Markets-The Edgeworth Box
The Box in its
simplest form
assumes: In this
We reduce the case:
THROUGH: • 2 Goods: Food (F)
‘all markets’
The and Shelter (S)
problem by the • 2 People: A and B
Edgeworth
use of two • Initial endowment:
Box (after
markets—since
Jevons  
EA  EAF , EAS &EB  EBF , EBS 
this is
Edgeworth)
manageable • Their consumption:
A 
X  X F, X S A A 
& X  X F , X S 
B B B

• Without Trade:
X A  E A & X B  EB
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 The Edgeworth Box, Pure Exchange-
Set up
With Trade:
• Many things can happen
but this is true:
X AF  X BF  EAF  EBF
X AS  X BS  EAS  EBS
Note the following elements:
(i) All resources in the
whole economy are
represented
(ii) The preferences of
both parties are
represented
(iii) The notion of
opportunity cost is
® clearly
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for use a s permitted
distributed with a certain product or service or otherwise on a password -protected website or school-approved learning management system for classroom use.
in a license
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 The Edgeworth Box, Pure Exchange-
Set up
From point E, the initial
endowment, where will both
parties end up if they are
allowed to trade?
• It is not fully clear
because either or both
could be made better off
without making either
worse off.
• But it’s clear that they
need to be somewhere in
the lens shaped region
(WHY?)- Because all of
these points Pareto
dominate E (defined in
bullet above).
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 The Edgeworth Box, Pure Exchange-
Set up
There are potential gains in
trade. A may prefer less of S and
vice versa and the same case for
B.
Hypothetically: S
• A gives up: E A  X S
A

• A gains: X AF  E AF
• B gives up: X A  E A
F F

• B gains: E AS  X AS
Are all points in the shape Pareto
Efficient? Not all some Pareto
superior some efficient. The
Indifference curves need to be
TANGENT for Pareto efficiency, so
trade should continue until
efficient point reached, otherwise
a bell can be drawn
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 Pareto Efficient Allocation
• No way to make all people better off
• Cannot make 1 person better off
without making at least 1 other
person worse off
• All gains from trade exhausted
 the indifference curves will be
Pareto tangent except in a corner
What are solution. Imagine if A didn’t like
efficient
the issues? shelter and B didn’t like food.
allocation
 Contract Curve (CC)--The set of
all Pareto efficient allocations
 No contract curve at corner solution
though it may still be Pareto
efficient– especially by giving the
entire endowment of F to A and the
entire endowment of S to B
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 Pareto efficient allocation-How do we get
from E to a point on the contract curve?
• Famous analogy: Auctioneer (Leon Walras Walrasian
auctioneer).
• In the initial endowment, the market clears (that is,
all goods consumed) but the allocation is not Pareto
efficient.
• So, an auctioneer could announce some prices and
then both parties could trade what they have for what
they preferred at these prices.
• Problem: Choices would then be Pareto efficient but
would not necessarily clear the market. It’s possible
there would be extra F and not enough S or vice
versa.
• So, must re-auction at new prices..............
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 Pareto efficient allocation-How do we get
from E to a point on the contract curve?
 At proposed prices:
 A wants to S and F
 A wants to S and F
 But, A wants to F more
than B wants to decrease
 A wants to S more than
B wants to increase
 So: X F
A  X B
F
 E A
F
 E F
B is

Excess Demand; and,

X AS  X BS  E AS  EBS is
Excess Supply.
With Excess DD or SS, then
allocation still inefficient—the
auctioneer should play with the
price ratio until market clears
12
®
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 Pareto efficient allocation-How do we get
from E to a point on the contract curve?
1. THEN: When the auctioneer gets the price ratio correct, the
market clears.
2. No excess demand or supply for any good---This is a
Market equilibrium, Competitive equilibrium,
Walrasian equilibrium.
3. In this equilibrium, each consumer is choosing his/her most
preferred bundle given prices and his initial endowment.
4. Each person’s optimal choice will therefore be the highest
indifference curve that is tangent to her budget set given
by the line with the slope PF /PS that intersects E.
5. Since choice sets (for A,B) are separated by the price ratio,
we know they will be tangent to one another but will not
intersect.
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 Pareto efficient allocation-How do we get
from E to a point on the contract curve?
1. This equilibrium price ratio will exist provided that:
 Each consumer has convex preferences (diminishing MRS)
 At a Pareto efficient allocation, the bundles preferred by agent A
and by agent B must be disjoint.
 Thus, if both agents have convex preferences we can draw a
straight line between the two sets of preferred bundles that
separates one from the other.
 The slope of this line gives us the relative prices.
 Each consumer is small relative to the aggregate size of the
market so that aggregate demand is continuous even if individual
preferences are not. (Is this relevant in a two case situation?
This is obviously not relevant in the two person case
represented by the Edgeworth box-----anyway all have at
least some market power)
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 Pareto efficient allocation-
Mathematical Approach
 By definition: A Pareto efficient
 We maximize:
allocation makes each agent as well-off
as possible given the utility of the max U ( X 1
, X 2
A A A)
other agent. X 1A , X A , X B , X B
2 1 2

 Assume we pick 𝑈 as utility level for  Such that: U B ( X B , X B ) ,

1 2

agent B and see how we can make A X 1A  X B1   1 and X A2  X B2   2

as well-off as possible.
 Lagrange:
 We have endowment for Goods 1 and 2
as:  1   1A   1B and  2   A2   B2 L  U A ( X 1A , X A2 )   (U B ( X B1 , X B2 )  U )
 Now is to find the allocation that makes  1 ( X 1A  X B1  1 )   2 ( X A2  X B2   2 )
A’s utility as large as possible given
fixed B’s utility and consumption equal  Then:λ is the lagrange
endowment i.e: X 1 , X 2 , X 1 , X 2  A A B B  multiplier on the utility
constraint and μ is the
lagrange multiplier on
resource contraints.
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 Pareto efficient allocation-
Mathematical Approach
 If we differentiate with respect to all the commodities:
L  U A ( X 1A , X A2 )   (U B ( X B1 , X B2 )  U )  1 ( X 1A  X B1   1 )   2 ( X A2  X B2   2 )
We obtain the following first order conditions:
L U A , L U A , L U B , L U B
    0     0       0     1  0
X A X A X B1 X B1 X B X B
1 1 1 1
X A2 X A2
2 1 1

If we divide the first term to second and third to fourth, we obtain:

U A / X 1A 1 U / X 1
1
MRS A    B B

U A / X A2  2 and
MRS
U B / X B2  2
B

IMPLICATIONS: At Pareto allocations, the marginal rates of

substitutions between two goods must be the same otherwise
there would be some trade which would make each consumer
better off. The langrange multiplier are the shadow prices or
efficient prices as it is when consumer maximise utility s.t BC
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