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
 Chapter 2: Fundamentals of
Welfare Economics
Welfare Economics
First Fundamental Theorem of
Welfare Economics
Second Fundamental Theorem of
Welfare Economics
 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 3
 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:
4
Makas Goods Graph

Ou is Makas food, and Ox

is Makas Video Games
Food

O x
Maka Video Games
5
Edgeworth Box Susan
r
y O Ow is Susans food,
and Oy is Susans
Video Games

Total food in the

Food

u w market is Or(=Os)
and total Video
Games is Os (=Or)
Each point in the
Edgeworth Box
O represents one
x s
possible good
Maka Video Games allocation 6
 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 7
Makas Utility Curves

Makas utility is greatest at M3

Food

M3
M2
M1
O
Maka Video Games
8
Edgeworth Box and Utility
Susan
r O Susan has the
highest utility at S3
S1
S2 A
S3 At point A, Maka
Food

has utility of M3 and

Susan has Utility of
M3 S2
M2
M1
O s
Maka Video Games
9
Edgeworth Box and Utility
Susan
r O If consumption is at
A, Maka has utility
M1 while Susan has
A utility S3
S3 B
Food

C By moving to point
B and then point C,
M3 Makas utility
M2 increases while
M1
Susans remains
constant
O s
Maka Video Games
10
Pareto Efficiency
Susan
r O Point C, where the
indifference curves
barely touch is
called PARETO
S3 EFFICIENT, as one
Food

C person cant be
made better off
M3
without harming the
M2
M1 other.

O s
Maka Video Games
11
 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:
12
Pareto Efficiency
Susan
r O If we start at point A:
-C is a pareto
improvement that
A makes Maka better
S3 off
Food

S4 C
-D is a pareto
S5 E improvement that
M3
makes Susan better
D M2
M1 off
-E is a pareto
improvement that
O s makes both better off
Maka Video Games
13
 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:
MRSVf Maka
MRSVf Susan

14
Pareto Efficiency Condition
The Contract Curve
Susan
r O
Food

O s
Maka Video Games
15
 MATH House and Chase
Assume that house and Chase have the following
utilities and MRS for books and coffee:

U House
B C ,U
H H Chase
B CC C

MRS House
BC C / B , MRS
H H Chase
BC C /B , C C

The Pareto Efficiency Condition therefore becomes:

MRS House
BC MRS Chase
BC ,
C /B C /B
H H C C

16
 MATH House and Chase
If there are 10 books, and 4 cups of coffee, then the
contract curve is expressed as:
MRS House
BC MRS Chase
BC ,
C / B (4 C ) /(10 B )
H H H H

If House has 6 books, a pareto efficient allocation

would be: H
C / 6 (4 C ) /(10 6)
H

4C 6(4 C )
H H

10C 24H

C 2.4
H 17
 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:

U House
B C
H H
6(2.4) 3.79
U Chase
B C 4(1.6) 2.52
C C

18
 Theory - Starting Point:
Economy 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

19
Production Possibilities Curve
Here the MRTSpr is equal to (7-
10 5)/(2-1)=-2, or two robots must be
9 given up for an extra pizza.
8
The marginal cost of the 3rd pizza,
7 or MCp=2 robots
6
Robots

The marginal cost of the 6th and 7th

5 robots, or MCr=1 pizza
4

3 Therefore, MRTxy=MCx/MCy
2
Therefore, MRTpr=2/1=2
1
1 2 3 4 5 6 7 8
20
Pizzas
 Efficiency and Production
If production is possible in an economy, the
Pareto efficiency condition becomes:

MRTxy MRS PersonA

xy MRS PersonB
xy
Assume MRTpr=3/4 and MRSpr=2/4.
-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
21
 Efficiency & Production Example
From the PPC, we know that:

MC x
MRT xy
MC y
We can therefore reinterpret Pareto efficiency
as:

MC x
MRS xy
PersonA
MRS xy
PersonB

MC y 22
 Theory - First Fundamental
Theorem Of Welfare
Economics
IF
1) 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
23
 First Fundamental Theorem of
Welfare Economics Origins
From microeconomic consumer theory, we
know that: P
MRS PersonA
xy x
Py
Since prices are the same for all people:

MRS PersonA
xy MRS PersonB
xy

Therefore economic theory gives us the first

part of Pareto efficiency
24
 First Fundamental Theorem of
Welfare Economics Origins
From basic economic theory, a perfect
competitive firm produces where P=MC,
therefore: MC P
x
x
MC y Py
But we know that MRT is the ratio of MCs,
therefore: P
MRTxy x
Py
25
 First Fundamental Theorem of
Welfare Economics Origins
Again from microeconomic consumer theory,
this changes to:
MRT xy MRS xy
Which satisfies the second requirement of
Pareto Efficiency
Therefore, we can expand Pareto Efficiency to
imply that
MC x Px
MRTxy MRS xy
PersonA
MRS xy
PersonB

MC y Py
26
 EfficiencyFairness
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
27

starves. This isnt typically socially optimal.

 Fairness
Susan
r O

B Points A and B are

Pareto efficient, but
C either Susan or Maka
get almost all societys
Food

resources
A
Many would argue C is
better for society, even
though it is not Pareto
O s efficient
Maka Video Games
28
 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: U=f(x,y), societal utility can be
seen as a function of individual utilities:
W=f(U1,U2)
This is referred to as the SOCIAL
WELFARE FUNCTION, and can produce
29

SOCIAL INDIFFERENCE CURVES:

 Utility Possibilities Curve
All points on the curve are
Pareto efficient, while all
B points below the curve are
not.
Makas Utility

Any point above the curve

is unobtainable
C

O
Maka Susans Utility
30
Typical Social Indifference
Curves
An indifference curve
farther from the origin
Makas Utility

represents a higher level of

social welfare.

O
Maka Susans Utility
31
 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

32
 Maximizing Social Welfare
ii is preferred to i, even
though ii is not Pareto
i efficient
Makas Utility

ii The highest possible social

welfare, iii, is Pareto
iii efficient

O
Maka Susans Utility
33
 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: 34
Second Fundamental Theorem
of Welfare Economics Susan
r O
Starting
Point

Goal
Food

O s
Maka Video Games
35
 Why Income Redistribution?
Why achieve equity through income
redistribution instead of taxes/penalties and
subsidies/incentives?
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.
36
 Why Is Government so Big?
1) Government has to ensure property laws
are protected. (1st Theorem)

2) Government has to redistribute income to

achieve equity. (2nd Theorem)

3) Often the assumptions of the First Welfare

Theorem do not hold (Chapter 3)
37
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?

38
 Merit Goods

Merit Good commodities that should be

provided even if society
a) 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) 39
 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?
40
 Welfare Economics Evaluation
Welfare Economics asks 3 questions of every
government action:

1) Will it have desirable distributional

consequences?
2) Will it enhance efficiency?
3) Is the cost reasonable?

-Although these questions may be difficult to

answer, they provide direction, and if they are all
41
no, the government shouldnt interfere