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Public 
Economics 
2013-­‐2014 
Topic 
3: 
Efficiency 
Manon 
Cuylits 
Ici, 
on 
a 
les 
3 
courbes 
d’indifférences 
d’Alice. 
Où 
que 
l’on 
se 
trouve 
sur 
la 
courbe 
d’indifférence, 
on 
tirera 
la 
même 
satisfaction, 
qu’on 
ait 
plus 
10 
de 
food 
et 
5 
de 
drink 
ou 
5 
de 
food 
et 
10 
de 
drink 
par 
exemple. 
Ici, 
on 
voit 
qu’il 
y 
a 
plusieurs 
courbes 
d’indifférence. 
L’humain 
préfèrera 
toujours 
avoir 
+, 
donc 
plus 
la 
courbe 
de 
satisfaction 
sur 
laquelle 
on 
se 
trouve 
est 
élevée, 
plus 
la 
satisfaction 
de 
l’humain 
(Alice 
ici) 
sera 
élevée. 
1 
Part 
II: 
Efficiency 
and 
market 
failures 
Topic 
3 
– 
Efficiency 
“All 
in 
all, 
climate 
change 
must 
be 
regarded 
as 
market 
failure 
on 
the 
greatest 
scale 
the 
world 
has 
seen” 
N. 
Stern 
(2006) 
The 
market 
efficiency 
can 
face 
4 
types 
of 
issues: 
1. No 
perfect 
competition: 
when 
we 
have 
monopolies, 
oligopolies, 
etc. 
there’s 
no 
efficient 
outcome 
possible 
2. Asymmetries 
of 
information1 
3. Public 
goods 
and 
externalities 
1. Introduction 
v Market 
and 
the 
role 
of 
governments 
v Main 
issue: 
do 
markets 
perform 
well? 
v Goal: 
have 
a 
general 
framework 
to 
organise 
thoughs 
about 
the 
desirability 
of 
various 
governmental 
actions 
v Welfare 
economics 
framework: 
branch 
of 
economic 
theory 
concerned 
with 
the 
social 
desirability 
of 
alternative 
economic 
states 
2. The 
concept 
of 
efficiency 
Rappel: 
les 
courbes 
d’indifférence: 
NB 
: 
On 
parle 
de 
courbes 
d’indifférence 
et 
de 
boite 
d’Edgeworth 
dans 
l’hypothèse 
d’une 
économie 
sans 
production, 
une 
économie 
d’échange. 
1 
On 
parle 
d’asymétrie 
de 
l’information 
en 
économie 
quand 
lors 
d’un 
échange, 
certains 
participants 
ont 
des 
informations 
pertinentes 
dont 
les 
autres 
ne 
disposent 
pas.
Public 
Economics 
2013-­‐2014 
Topic 
3: 
Efficiency 
Manon 
Cuylits 
2 
La 
boite 
d’Edgeworth 
Robinson 
et 
Vendredi 
vont 
donc 
échanger 
jusqu’à 
ce 
qu’il 
n’y 
ait 
plus 
d’échanges 
mutuels 
avantageux 
possibles. 
Une 
fois 
arrivés 
à 
ces 
points, 
on 
atteint 
des 
« 
optimum 
de 
Pareto 
», 
ils 
se 
situent 
au 
croisement 
des 
courbes 
d’indifférence 
des 
deux 
individus. 
Concept 
of 
efficiency 
Pareto 
Improvement 
= 
Reallocation 
of 
resources 
that 
makes 
at 
least 
one 
person 
better 
off 
without 
making 
anyone 
else 
worse 
off. 
Ici 
on 
a 
les 
courbes 
d’indifférence 
de 
Robinson, 
et 
celles 
de 
Vendredi 
représentées 
dans 
l’autre 
sens. 
Les 
deux 
vont 
vouloir 
maximiser 
leur 
satisfaction 
et 
donc 
se 
retrouver 
sur 
la 
courbe 
d’indifférence 
la 
plus 
élevée 
possible. 
Plus 
on 
va 
vers 
le 
coin 
en 
haut 
à 
droite, 
plus 
la 
satisfaction 
de 
Robinson 
augmente, 
et 
plus 
on 
va 
vers 
le 
coin 
en 
bas 
à 
droite, 
plus 
la 
satisfaction 
de 
Vendredi 
augmente 
Making 
Bob 
better 
off 
while 
not 
making 
Alice 
worse 
off 
Making 
Alice 
better 
off 
while 
not 
making 
Bob 
worse 
off
Public 
Economics 
2013-­‐2014 
Topic 
3: 
Efficiency 
Manon 
Cuylits 
If 
we 
let 
the 
market 
go, 
we 
can 
move 
to 
another 
location 
that 
will 
improve 
the 
situation 
of 
at 
least 
one 
actor 
without 
deteriorating 
the 
situation 
of 
another 
one 
3 
Pareto 
efficient 
allocation 
= 
allocation 
such 
that 
no 
person 
can 
be 
made 
better 
off 
without 
making 
another 
person 
worse 
off. 
In 
case 
of 
efficient 
allocations, 
there 
are 
no 
wasted 
resources. 
(See 
appendix 
for 
more 
information) 
As 
we 
can 
see 
it 
above, 
the 
condition 
for 
Pareto 
efficiency 
is 
to 
have 
indifference 
curves 
that 
are 
tangent. 
Thus 
MRSAD,F 
= 
MRSBD,F 
è(MRSAliceDrink,Food 
= 
MRSBobDrink,Food) 
è 
Intuition 
(example): 
when 
MRS 
differ 
across 
individuals, 
there’s 
an 
incentive 
to 
trade. 
Marginal 
Rate 
of 
Substitution 
(MRS) 
= 
the 
rate 
at 
which 
the 
individual 
is 
willing 
to 
trade 
one 
good 
for 
an 
additional 
amount 
of 
another. 
è 
Le 
taux 
marginal 
de 
substitution 
c’est 
le 
nombre 
de 
biens 
« 
food 
» 
qu’un 
individu 
est 
prêt 
à 
céder 
en 
échange 
d’une 
unité 
supplémentaire 
de 
biens 
« 
drink 
» 
(ou 
l’inverse), 
cela 
peut 
aussi 
être 
la 
quantité 
minimale 
de 
bien 
« 
food 
» 
que 
l’individu 
exige 
pour 
céder 
un 
bien 
« 
drink 
» 
(ou 
l’inverse). 
è 
this 
it 
the 
concept 
of 
Pareto 
Efficiency
Public 
Economics 
2013-­‐2014 
Topic 
3: 
Efficiency 
Manon 
Cuylits 
4 
Economy 
with 
production 
We 
have 
to 
decide 
how 
we 
organize 
the 
production. 
We 
can 
decide 
between 
producing 
more 
food 
and 
less 
drink, 
or 
producing 
more 
drink 
and 
less 
food. 
We 
have 
to 
reach 
efficiency 
in 
production, 
not 
only 
in 
consumption. 
In 
our 
economy, 
it’s 
the 
same: 
we 
have 
to 
decide 
whether 
we 
should 
produce 
more 
medical 
services 
and 
fewer 
cars 
for 
example. 
If 
we 
could 
do 
better 
for 
some 
people 
without 
doing 
worse 
for 
other 
people, 
it 
would 
mean 
we 
might 
organize 
our 
economy 
in 
that 
way 
and 
reach 
a 
situation 
that 
would 
be 
more 
efficient. 
Marginal 
Rate 
of 
Transformation 
= 
the 
rate 
at 
which 
the 
economy 
can 
transform 
one 
good 
into 
another 
one 
(slope 
of 
the 
production 
possibilities 
curves). 
Condition 
for 
efficiency 
within 
production: 
MRTD,F 
= 
MRSAD,F 
= 
MRSBD,F 
è 
without 
this 
equality, 
we 
don’t 
have 
efficiency. 
If 
the 
society 
is 
not 
organized 
in 
a 
good 
way, 
it 
means 
there’s 
room 
for 
changes 
that 
could 
make 
it 
more 
efficient. 
As 
a 
condition 
for 
efficiency, 
the 
slope 
between 
2 
goods 
(food 
and 
drink) 
should 
be 
equal 
to 
the 
marginal 
rate 
of 
substitution 
of 
the 
different 
customers. 
è 
Intuition: 
Up 
to 
now, 
we 
just 
talked 
about 
allocations 
of 
resources. 
How 
to 
organise 
a 
society 
so 
as 
to 
reach 
a 
Pareto 
efficient 
allocation? 
And 
do 
market 
economies 
lead 
to 
Pareto 
efficient 
allocation?
Public 
Economics 
2013-­‐2014 
Topic 
3: 
Efficiency 
Manon 
Cuylits 
5 
3. The 
first 
fundamental 
theorem 
of 
welfare 
economics 
The 
first 
fundamental 
theorem 
of 
welfare 
economics: 
“as 
long 
as 
producers 
and 
consumers 
act 
as 
perfect 
competitors, 
that 
is, 
take 
prices 
as 
given, 
then 
under 
certain 
conditions 
(see 
later) 
a 
Pareto 
efficient 
allocation 
of 
resources 
emerges” 
Key 
role 
of 
prices: 
Actor 
Consumers 
푀푅푆!,! = 
푃! 
푃! 
• PD 
= 
Price 
of 
D 
• PF 
= 
Price 
of 
F 
Producers 
푀퐶! = 푃! 
푎푛푑 푀퐶! = 푃! 
푃! 
푃! 
= 
푀퐶! 
푀퐶! 
= 푀푅푇!,! 
THUS 
푀푅푆!,! = 푀푅푇!,! 
è 
Condition 
for 
efficiency 
è 
If 
you 
let 
people 
do 
what 
they 
want 
to 
do, 
you’ll 
have 
an 
enforcement 
of 
property 
rights, 
and 
then 
you 
let 
the 
market 
go. 
You’ll 
have 
an 
organization 
of 
the 
society 
that 
will 
be 
efficient, 
meaning 
that 
we 
won’t 
be 
able 
to 
improve 
the 
satisfaction 
of 
some 
users 
without 
diminishing 
the 
one 
of 
others. 
BUT, 
therefore, 
we 
need 
some 
conditions 
to 
be 
fulfilled: 
we 
need 
perfect 
competitions 
+ 
other 
conditions 
(see 
later). 
Those 
conditions 
are 
not 
actually 
met. 
This 
takes 
place 
through 
the 
crises 
of 
resources, 
of 
the 
goods 
we 
sell. 
The 
prices 
are 
giving 
signals 
and 
are 
orienting 
the 
economy: 
supply/demand 
law. 
è 
If 
the 
supply 
is 
lower 
and 
the 
demand 
is 
higher, 
the 
price 
will 
rise. 
It 
means 
that 
only 
the 
people 
valuing 
the 
price 
of 
the 
good 
really 
high 
are 
going 
to 
pay 
for 
this 
good. 
This 
is 
done 
in 
order 
to 
avoid 
wasting 
resources 
(efficiency). 
In 
a 
nutshell, 
a 
competitive 
economy 
(decentralisation, 
Adam 
Smith 
‘invisible 
hand’) 
leads 
to 
efficiency, 
and 
that’s 
really 
powerful. 
There’s 
a 
key 
role 
of 
prices. 
There’s 
a 
role 
for 
a 
government: 
even 
under 
perfect 
competition 
and 
when 
there 
are 
“certain 
conditions” 
that 
are 
met, 
there’s 
a 
role 
for 
a 
government: 
• Protect 
property 
rights 
so 
that 
markets 
can 
work 
(ex: 
justice), 
that 
the 
minimal 
role 
of 
a 
government 
• Deal 
with 
fairness/equity 
4. The 
role 
of 
fairness/equity 
Among 
Pareto 
efficient 
(PE) 
allocations, 
which 
one? 
(see 
Edgeworth 
box) 
Observation: 
a 
non-­‐Pareto 
Efficient 
allocation 
(ex: 
y 
that’s 
not 
on 
the 
contract 
curve) 
might 
be 
preferred 
to 
a 
Pareto 
Efficient 
allocation 
(ex: 
x 
or 
z 
that 
are 
on 
the 
contract 
curve) 
from 
the 
society’s 
point 
of 
view.
Public 
Economics 
2013-­‐2014 
Topic 
3: 
Efficiency 
Manon 
Cuylits 
Here, 
we 
might 
think 
an 
allocation 
such 
as 
y 
is 
not 
efficient, 
because 
it’s 
not 
on 
the 
contract 
curve, 
but 
actually, 
it 
is 
efficient 
(same 
for 
x 
and 
z 
that 
are 
on 
the 
contract 
curve). 
The 
contract 
curve 
= 
the 
maximum 
utility 
we 
can 
give 
to 
Alice 
or 
Bob 
How 
do 
you 
compare 
the 
utilities 
of 
different 
persons? 
It’s 
a 
tricky 
question. 
We’ll 
look 
at 
the 
social 
indifference 
curves 
(SIC). 
If 
we 
have 
the 
utility 
of 
A 
and 
B, 
we 
have 
the 
same 
satisfaction, 
so 
the 
same 
W. 
Each 
curve 
is 
a 
social 
difference 
curve 
and 
The 
map 
= 
the 
social 
indifference 
curves 
6 
Tools: 
Utility 
possibilities 
curves 
(UPC) 
and 
social 
indifference 
curves 
(social 
welfare 
functions). 
Social 
indifference 
curves 
(SIC) 
and 
Here 
we 
see 
the 
utility 
possibilities 
curves: 
• The 
utility 
is 
maximal 
for 
Alice 
if 
you 
give 
everything 
to 
Alice 
• The 
utility 
is 
maximal 
for 
Bob 
if 
you 
give 
Bob 
everything 
social 
welfare 
functions 
(SWF): 
푊 = 푓 푈!"#$%,푈!"# 
푤푖푡ℎ 푈!"#$% 퐹,퐷 푎푛푑 푈!"#(퐹,퐷) 
Social 
welfare 
framework 
= 
social 
welfare 
functions: 
you 
have 
to 
decide 
for 
everyone. 
If 
you 
look 
at 
people 
in 
terms 
of 
their 
utilities, 
you 
have 
to 
take 
some 
decisions 
to 
allocate 
the 
resources, 
then 
you 
have 
to 
aggregate 
so 
you 
have 
the 
utilities 
of 
everyone. 
Satisfaction 
can 
come 
from 
the 
fact 
you’re 
wearing 
nice 
clothes, 
driving 
a 
nice 
car 
etc. 
but 
it 
could 
also 
come 
from 
the 
fact 
you 
look 
at 
nice 
landscapes, 
etc.
Public 
Economics 
2013-­‐2014 
Topic 
3: 
Efficiency 
Manon 
Cuylits 
Here, 
you 
look 
at 
the 
utility 
of 
everyone 
(the 
utility 
of 
Bob 
and 
the 
utility 
of 
Alice) 
and 
then 
you 
try 
to 
find 
one 
number: 
W. 
This 
number 
will 
depend 
on 
what 
you 
put 
in 
the 
utilities 
of 
Bob 
and 
Alice 
(cars, 
etc.). 
Then 
you 
can 
decide 
to 
do 
something 
else: 
You 
could 
decide 
you’d 
like 
people 
to 
be 
more 
taking 
care 
of 
older 
people, 
etc. 
7 
è 
you 
search 
for 
the 
greatest/highest 
W. 
More 
on 
social 
welfare 
functions: 
two 
extreme 
cases 
♥ Utilitarianism: 
W 
= 
U1 
+ 
U2 
+ 
… 
+ 
UN 
♥ Maximin 
criterion: 
W 
= 
min 
(U1 
+ 
U2 
+ 
… 
+ 
UN) 
Half-­‐half 
B 
has 
some 
utility 
and 
A 
has 
none: 
A 
is 
starving 
Le 
maximin 
= 
maximiser 
le 
sort 
de 
la 
catégorie 
la 
plus 
défavorisée, 
le 
sort 
de 
ceux 
qui 
ont 
le 
moins. 
Level 
of 
utility: 
Here 
we 
could 
decide 
to 
give 
all 
the 
utility 
to 
A 
or 
all 
the 
utility 
to 
B, 
or 
to 
be 
just 
in 
the 
middle: 
half-­‐half 
Here 
we 
take 
the 
minimum 
within 
all 
the 
utilities 
of 
all 
the 
people 
(John 
Rawls): 
We 
look 
at 
the 
poorest 
person. 
If 
we 
want 
to 
raise 
the 
social 
welfare, 
we 
have 
to 
raise 
the 
satisfaction 
of 
the 
poorest 
person, 
so 
we 
have 
to 
allocate 
more 
resources 
to 
the 
poor 
people.
Public 
Economics 
2013-­‐2014 
Topic 
3: 
Efficiency 
Manon 
Cuylits 
8 
Choice 
of 
the 
fair 
(and 
efficient) 
allocation: 
5. The 
second 
fundamental 
theorem 
of 
welfare 
economics 
The 
second 
fundamental 
theorem 
of 
welfare 
economics: 
“Any 
Pareto 
efficient 
allocation 
can 
be 
attained 
by 
making 
a 
suitable 
assignment 
of 
initial 
endowments2 
and 
letting 
people 
trade 
with 
each 
other”. 
Hence, 
interventions 
on 
market 
themselves 
is 
not 
necessary, 
redistributing 
income 
is 
enough. 
Initial 
endowment: 
If 
we 
start 
from 
such 
an 
allocation 
and 
let 
the 
market 
work, 
Alice 
will 
give 
some 
of 
her 
drinks 
to 
Bob, 
in 
exchange 
with 
Bob’s 
food, 
so 
Alice 
will 
have 
fewer 
drinks 
and 
more 
food, 
and 
Bob 
will 
have 
more 
drinks 
and 
less 
food 
than 
at 
the 
beginning. 
Here 
we 
let 
the 
market 
work, 
we 
just 
have 
to 
redistribute 
endowments. 
The 
government 
redistributes 
income 
mainly 
through 
thanks 
to 
taxes: 
they 
redistribute 
through 
the 
tax 
system. 
2 
Dotation 
initiale 
If 
I’m 
a 
social 
planner, 
I 
will 
look 
at 
all 
these 
curves 
and 
chose 
the 
level 
at 
which 
the 
utility 
is 
the 
highest. 
Here 
we 
have: 
♥ The 
utility 
possibilities 
curve 
♥ The 
indifference 
curves 
The 
point 
where 
curves 
meet 
is 
more 
efficient 
that 
the 
rest 
of 
the 
utilities 
curves. 
This 
is 
the 
point 
where 
this 
is 
the 
best 
at 
the 
society 
point 
of 
view.
Public 
Economics 
2013-­‐2014 
Topic 
3: 
Efficiency 
Manon 
Cuylits 
Redistribution 
of 
initial 
endowments 
9 
GDP 
= 
Gross 
Domestic 
Product 
= 
what 
is 
produced 
in 
a 
year. 
Half 
of 
the 
GDP 
is 
subject 
to 
taxes. 
The 
government 
has 
the 
power 
to 
take 
half 
of 
the 
GDP 
and 
to 
redistribute 
it 
through 
various 
allocations 
(example: 
the 
fact 
that 
education 
is 
free 
until 
18 
years 
old, 
etc.). 
We 
really 
benefit 
from 
the 
money 
redistribution. 
The 
public 
intervention 
is 
really 
significant 
and 
powerful 
è 
the 
government 
taxes 
income, 
with 
higher 
taxes 
for 
people 
with 
higher 
revenues. 
The 
taxes 
are 
not 
proportional 
taxes 
but 
progressive 
taxes: 
if 
we 
have 
an 
income 
of 
10, 
we 
will 
pay 
1 
of 
taxes, 
but 
if 
we 
have 
an 
income 
of 
100, 
we 
will 
pay 
more 
than 
10 
of 
taxes. 
Equity-­‐Efficiency 
trade-­‐off 
Problem: 
government 
needs 
some 
way 
to 
reallocate 
resources 
and 
those 
mechanisms 
usually 
induce 
inefficiencies 
(e.g. 
income 
tax) 
Thus, 
in 
practice, 
there 
is 
to 
some 
extent 
a 
trade-­‐off 
between 
efficiency 
and 
equity. 
The 
3 
main 
ways 
to 
collect 
money 
= 
♥ VAT 
♥ Tax 
income 
♥ … 
When 
we 
use 
tax 
income 
to 
collect 
money, 
people 
that 
are 
working 
know 
they 
will 
have 
much 
less 
than 
what 
they 
have 
truly 
earned 
while 
working. 
It 
does 
not 
encourage 
them 
to 
work 
much. 
It’s 
the 
same 
for 
VAT, 
if 
someone 
likes 
something, 
the 
fact 
he 
has 
to 
pay 
VAT 
when 
he 
buys 
it 
is 
a 
disincentive 
event. 
The 
government 
has 
to 
find 
a 
way 
to 
deal 
with 
that 
problem 
of 
disincentive 
events. 
è 
When 
we 
have 
a 
tax 
system, 
we 
need 
to 
create 
efficiency 
because 
the 
tax 
system 
creates 
a 
disincentive. 
If 
we 
want 
to 
move 
from 
an 
allocation 
we 
think 
is 
not 
fair 
because 
Alice 
has 
everything 
and 
Bob 
has 
nothing, 
if 
we 
do 
not 
move 
ON 
the 
curve, 
we 
lose 
some 
efficiency.
Public 
Economics 
2013-­‐2014 
Topic 
3: 
Efficiency 
Manon 
Cuylits 
10 
Excess 
burden 
of 
taxation: 
the 
window 
tax 
example 
1696-­‐1851: 
“when 
the 
window 
tax 
was 
introduced, 
it 
consisted 
of 
2 
parts: 
• A 
flat-­‐rate 
house 
tax 
of 
2 
shillings 
per 
house 
and 
• A 
variable 
tax 
for 
the 
number 
of 
windows 
above 
ten 
windows. 
Properties 
with 
between 
ten 
and 
twenty 
windows 
paid 
a 
total 
of 
four 
shillings, 
and 
those 
above 
twenty 
windows 
paid 
eight 
shillings”. 
è 
Depending 
on 
the 
number 
of 
windows 
we 
had 
on 
our 
house, 
we 
had 
to 
pay 
more 
or 
less 
taxes. 
This 
could 
create 
a 
disincentive 
to 
having 
windows. 
This 
was 
not 
the 
purpose 
of 
having 
such 
a 
taxation 
system. 
6. Conditions 
under 
which 
markets 
do 
not 
lead 
to 
efficiency 
Back 
to 
the 
first 
fundamental 
theorem 
of 
welfare 
economics: 
possible 
market 
failures. 
• Imperfect 
competition: 
Imperfect 
competition 
arises 
when 
agents 
have 
the 
ability 
to 
influence 
the 
price 
of 
a 
commodity 
(monopoly, 
oligopoly, 
product 
differentiation, 
etc.) 
It 
leads 
to 
prices 
above 
marginal 
costs 
or 
above 
marginal 
productivity. 
Conditions 
for 
efficiency 
are 
violated. 
For 
example, 
in 
the 
case 
of 
monopolies, 
prices 
are 
above 
the 
marginal 
cost: 
it 
means 
companies 
are 
capturing 
rents, 
they 
could 
produce 
more, 
so 
it’s 
not 
efficient. 
Ex: 
the 
electricity 
market: 
there 
are 
some 
measures 
taken 
on 
the 
concentration 
of 
producers, 
it 
has 
an 
impact 
on 
the 
price. 
• Asymmetric 
information: 
Asymmetric 
information 
is 
present 
when 
a 
party 
engaged 
in 
an 
economic 
transaction 
has 
better 
information 
about 
the 
good 
and 
service 
traded 
than 
the 
other 
party. 
Ex: 
insurance 
against 
the 
possibility 
of 
becoming 
poor. 
Everyone 
doesn’t 
know 
the 
same 
things. 
Ex: 
social 
security 
-­‐ 
example 
of 
a 
public 
intervention: 
there’s 
asymmetric 
intervention. 
In 
Europe, 
we 
have 
a 
social 
security 
system 
very 
well 
developed 
compared 
to 
other 
countries. 
Many 
people 
will 
have 
the 
possibility 
to 
be 
insured 
(private 
insurance); 
however, 
many 
people 
don’t 
have 
the 
possibility 
to 
be 
insured 
because 
they 
are 
too 
poor 
and, 
moreover, 
it’s 
not 
efficient, 
it 
is 
not 
covering 
all 
the 
sorts 
of 
disease. 
There’s 
asymmetric 
information 
between 
the 
doctor 
and 
the 
patient 
for 
example. 
• Public 
Good: 
A 
public 
good 
is 
a 
good 
that 
is 
non-­‐rival 
and 
non-­‐excludable 
in 
consumption, 
for 
example 
the 
roads. 
è 
Un 
bien 
public 
est 
un 
bien 
que 
chacun 
peut 
consommer 
en 
même 
temps, 
en 
même 
quantité 
et 
dans 
sa 
totalité. 
On 
ne 
peut 
pas 
exclure 
quelqu’un 
de 
l’accès 
à 
ce 
bien 
(non-­‐ 
excludable), 
si 
quelqu’un 
utilise 
ce 
bien, 
cela 
n’empêche 
personne 
de 
l’utiliser 
aussi 
(non-­‐rival), 
et 
au 
niveau 
de 
la 
production, 
le 
cout 
marginal 
= 
0, 
cela 
veut 
dire 
que 
pour 
une 
personne 
supplémentaire 
utilisant 
ce 
bien, 
le 
cout 
est 
nul, 
cela 
ne 
change 
rien 
qu’une 
personne 
en 
plus 
utilise 
la 
route 
par 
exemple. 
• Externalities: 
An 
externality 
is 
an 
activity 
of 
one 
entity 
that 
affects 
the 
welfare 
of 
another 
entity 
in 
a 
way 
that 
is 
outside 
the 
market. 
Ex: 
airplane 
noise 
pollution.
Public 
Economics 
2013-­‐2014 
Topic 
3: 
Efficiency 
Manon 
Cuylits 
On 
parle 
d’externalités 
dans 
une 
situation 
économique 
ou 
l’acte 
d’un 
agent 
influe 
positivement 
(externalités 
positives) 
ou 
négativement 
(externalités 
négatives) 
sur 
la 
situation 
d’un 
autre 
agent 
non-­‐impliqué 
dans 
l’action, 
sans 
que 
ce 
dernier 
ne 
soit 
totalement 
compensé 
ou 
n’ait 
à 
payer 
pour 
les 
dommages 
et 
bénéfices 
engendrés. 
Exemple 
d’externalités 
négatives 
: 
la 
pollution 
Public 
goods 
and 
externalities 
are 
dealing 
with 
the 
existence 
of 
public 
goods 
and 
the 
fact 
that 
we 
have 
externalities. 
When 
there 
are 
public 
goods, 
the 
market 
will 
never 
be 
efficient. 
NB: 
in 
asymmetric 
information, 
public 
good 
and 
externalities, 
markets 
are 
missing. 
11 
7. Conclusion 
Two 
criteria 
to 
evaluate 
the 
state 
of 
an 
economy 
(an 
allocation 
of 
resources): 
• Efficiency 
(Pareto 
efficiency): 
no 
waste 
• Equity/fairness: 
social 
welfare 
function 
approach 
“Role” 
of 
markets: 
Competitive 
markets 
lead 
to 
efficiency 
when 
there 
is 
a 
market 
for 
each 
and 
every 
commodity 
(i.e. 
no 
imperfect 
competition, 
no 
public 
goods, 
no 
externalities). 
Role 
of 
a 
government: 
• Enhance 
efficiency: 
deal 
with 
market 
failures 
(imperfect 
competition 
and 
missing 
markets) 
and 
minimal 
role 
of 
property 
right 
protection 
• Enhance 
equity: 
deal 
with 
distributional 
issues 
Possible 
trade-­‐off 
between 
efficiency 
and 
equity. 
Appendix 
1: 
a 
note 
on 
social 
choice 
How 
do 
we, 
as 
society, 
choose 
a 
(desired) 
point 
along 
the 
UPF3? 
We 
need 
a 
“social 
choice 
function 
(SCF)”, 
an 
ordinal 
ranking 
of 
the 
alternatives. 
• What 
criteria 
should 
such 
a 
function 
have? 
• How 
do 
we 
choose 
which 
function 
is 
the 
right 
one? 
A 
social 
planner 
is 
a 
kind 
of 
cop. 
How 
do 
we 
decide 
what 
to 
do? 
We 
do 
vote/elect 
politicians. 
They 
have 
programs 
regarding 
intervention 
on 
the 
market. 
They 
are 
writing 
laws 
intervening 
on 
the 
economy: 
the 
allocation 
of 
resources 
includes 
fiscal 
instruments 
è 
they 
do 
define 
a 
program 
with 
more 
taxes 
on 
companies, 
more 
redistributions, 
etc. 
for 
example. 
è 
The 
way 
those 
things 
(programs) 
take 
place 
in 
reality 
= 
through 
democracy, 
etc. 
3 
Utility 
Possibility 
Frontier
Public 
Economics 
2013-­‐2014 
Topic 
3: 
Efficiency 
Manon 
Cuylits 
12 
Arrow’s 
impossibility 
theorem 
(no 
question 
at 
the 
exam) 
• Pareto 
principle: 
“If 
at 
least 
one 
individual 
prefers 
option 
x 
to 
option 
y 
and 
no 
one 
strictly 
prefers 
y 
to 
x 
then 
society 
prefers 
x 
to 
y” 
• Universal 
domain: 
The 
SCF 
should 
work 
for 
any 
set 
of 
individual 
preferences 
(no 
matter 
how 
weird). 
• Non-­‐Dictatorship: 
The 
SCF 
should 
not 
depend 
solely 
on 
the 
rankings 
of 
one 
individual 
• Independence 
of 
irrelevant 
alternatives: 
The 
ranking 
of 
x 
and 
y 
should 
only 
depend 
on 
individual 
rankings 
of 
x 
and 
y 
and 
not 
on 
the 
preferences 
of 
individuals 
over 
x 
and 
z 
(nor 
y 
and 
z). 
Arrow: 
Any 
SCF 
should 
be 
complete 
and 
transitive 
and 
satisfy 
these 
four 
criteria. 
However, 
no 
SCF 
can 
satisfy 
these 
four 
criteria 
Condorcet’s 
Paradox 
(as 
an 
illustration 
of 
Arrow’s 
impossibility 
theorem) 
Rankings 
of 
alternatives, 
example 
• Liberals: 
Green 
Park 
> 
Public 
housing 
> 
Private 
housing 
• Labour: 
Public 
housing 
> 
Private 
Housing 
> 
Green 
Park 
• Conservatives: 
Private 
Housing 
> 
Green 
Park 
> 
Public 
housing 
Consider 
majority 
rule 
as 
a 
“social 
choice 
function”: 
When 
considering 
two 
policies, 
select 
the 
one 
that 
more 
people 
prefer. 
This 
will 
satistfy 
PUDI. 
But 
in 
the 
case 
above, 
the 
choice 
will 
depend 
on 
the 
way 
these 
are 
paired 
(as 
in 
Rocks-­‐ 
Paper-­‐Scissors). 
“Society 
prefers” 
Green 
Park 
to 
Public 
housing, 
Private 
housing 
to 
a 
Green 
park, 
and 
Public 
housing 
to 
Private 
housing. 
è 
Social 
preferences 
are 
not 
transitive. 
Appendix 
2: 
Pure 
exchange 
economy 
• 2 
goods: 
Food 
and 
Drink 
• 2 
people: 
Alice 
and 
Bob 
Note: 
results 
hold 
for 
many 
people 
and 
commodities 
è 
The 
Edgeworth 
box:
Public 
Economics 
2013-­‐2014 
Topic 
3: 
Efficiency 
Manon 
Cuylits 
Each 
point 
is 
a 
basket 
of 
goods 
(food 
and 
drinks). 
13 
Alice 
Bob 
è 
Together 
A 
possible 
initial 
location 
Same 
level 
of 
satisfaction 
for 
any 
basket 
on 
a 
given 
indifference 
curve.

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Topic 3 - efficiency

  • 1. Public Economics 2013-­‐2014 Topic 3: Efficiency Manon Cuylits Ici, on a les 3 courbes d’indifférences d’Alice. Où que l’on se trouve sur la courbe d’indifférence, on tirera la même satisfaction, qu’on ait plus 10 de food et 5 de drink ou 5 de food et 10 de drink par exemple. Ici, on voit qu’il y a plusieurs courbes d’indifférence. L’humain préfèrera toujours avoir +, donc plus la courbe de satisfaction sur laquelle on se trouve est élevée, plus la satisfaction de l’humain (Alice ici) sera élevée. 1 Part II: Efficiency and market failures Topic 3 – Efficiency “All in all, climate change must be regarded as market failure on the greatest scale the world has seen” N. Stern (2006) The market efficiency can face 4 types of issues: 1. No perfect competition: when we have monopolies, oligopolies, etc. there’s no efficient outcome possible 2. Asymmetries of information1 3. Public goods and externalities 1. Introduction v Market and the role of governments v Main issue: do markets perform well? v Goal: have a general framework to organise thoughs about the desirability of various governmental actions v Welfare economics framework: branch of economic theory concerned with the social desirability of alternative economic states 2. The concept of efficiency Rappel: les courbes d’indifférence: NB : On parle de courbes d’indifférence et de boite d’Edgeworth dans l’hypothèse d’une économie sans production, une économie d’échange. 1 On parle d’asymétrie de l’information en économie quand lors d’un échange, certains participants ont des informations pertinentes dont les autres ne disposent pas.
  • 2. Public Economics 2013-­‐2014 Topic 3: Efficiency Manon Cuylits 2 La boite d’Edgeworth Robinson et Vendredi vont donc échanger jusqu’à ce qu’il n’y ait plus d’échanges mutuels avantageux possibles. Une fois arrivés à ces points, on atteint des « optimum de Pareto », ils se situent au croisement des courbes d’indifférence des deux individus. Concept of efficiency Pareto Improvement = Reallocation of resources that makes at least one person better off without making anyone else worse off. Ici on a les courbes d’indifférence de Robinson, et celles de Vendredi représentées dans l’autre sens. Les deux vont vouloir maximiser leur satisfaction et donc se retrouver sur la courbe d’indifférence la plus élevée possible. Plus on va vers le coin en haut à droite, plus la satisfaction de Robinson augmente, et plus on va vers le coin en bas à droite, plus la satisfaction de Vendredi augmente Making Bob better off while not making Alice worse off Making Alice better off while not making Bob worse off
  • 3. Public Economics 2013-­‐2014 Topic 3: Efficiency Manon Cuylits If we let the market go, we can move to another location that will improve the situation of at least one actor without deteriorating the situation of another one 3 Pareto efficient allocation = allocation such that no person can be made better off without making another person worse off. In case of efficient allocations, there are no wasted resources. (See appendix for more information) As we can see it above, the condition for Pareto efficiency is to have indifference curves that are tangent. Thus MRSAD,F = MRSBD,F è(MRSAliceDrink,Food = MRSBobDrink,Food) è Intuition (example): when MRS differ across individuals, there’s an incentive to trade. Marginal Rate of Substitution (MRS) = the rate at which the individual is willing to trade one good for an additional amount of another. è Le taux marginal de substitution c’est le nombre de biens « food » qu’un individu est prêt à céder en échange d’une unité supplémentaire de biens « drink » (ou l’inverse), cela peut aussi être la quantité minimale de bien « food » que l’individu exige pour céder un bien « drink » (ou l’inverse). è this it the concept of Pareto Efficiency
  • 4. Public Economics 2013-­‐2014 Topic 3: Efficiency Manon Cuylits 4 Economy with production We have to decide how we organize the production. We can decide between producing more food and less drink, or producing more drink and less food. We have to reach efficiency in production, not only in consumption. In our economy, it’s the same: we have to decide whether we should produce more medical services and fewer cars for example. If we could do better for some people without doing worse for other people, it would mean we might organize our economy in that way and reach a situation that would be more efficient. Marginal Rate of Transformation = the rate at which the economy can transform one good into another one (slope of the production possibilities curves). Condition for efficiency within production: MRTD,F = MRSAD,F = MRSBD,F è without this equality, we don’t have efficiency. If the society is not organized in a good way, it means there’s room for changes that could make it more efficient. As a condition for efficiency, the slope between 2 goods (food and drink) should be equal to the marginal rate of substitution of the different customers. è Intuition: Up to now, we just talked about allocations of resources. How to organise a society so as to reach a Pareto efficient allocation? And do market economies lead to Pareto efficient allocation?
  • 5. Public Economics 2013-­‐2014 Topic 3: Efficiency Manon Cuylits 5 3. The first fundamental theorem of welfare economics The first fundamental theorem of welfare economics: “as long as producers and consumers act as perfect competitors, that is, take prices as given, then under certain conditions (see later) a Pareto efficient allocation of resources emerges” Key role of prices: Actor Consumers 푀푅푆!,! = 푃! 푃! • PD = Price of D • PF = Price of F Producers 푀퐶! = 푃! 푎푛푑 푀퐶! = 푃! 푃! 푃! = 푀퐶! 푀퐶! = 푀푅푇!,! THUS 푀푅푆!,! = 푀푅푇!,! è Condition for efficiency è If you let people do what they want to do, you’ll have an enforcement of property rights, and then you let the market go. You’ll have an organization of the society that will be efficient, meaning that we won’t be able to improve the satisfaction of some users without diminishing the one of others. BUT, therefore, we need some conditions to be fulfilled: we need perfect competitions + other conditions (see later). Those conditions are not actually met. This takes place through the crises of resources, of the goods we sell. The prices are giving signals and are orienting the economy: supply/demand law. è If the supply is lower and the demand is higher, the price will rise. It means that only the people valuing the price of the good really high are going to pay for this good. This is done in order to avoid wasting resources (efficiency). In a nutshell, a competitive economy (decentralisation, Adam Smith ‘invisible hand’) leads to efficiency, and that’s really powerful. There’s a key role of prices. There’s a role for a government: even under perfect competition and when there are “certain conditions” that are met, there’s a role for a government: • Protect property rights so that markets can work (ex: justice), that the minimal role of a government • Deal with fairness/equity 4. The role of fairness/equity Among Pareto efficient (PE) allocations, which one? (see Edgeworth box) Observation: a non-­‐Pareto Efficient allocation (ex: y that’s not on the contract curve) might be preferred to a Pareto Efficient allocation (ex: x or z that are on the contract curve) from the society’s point of view.
  • 6. Public Economics 2013-­‐2014 Topic 3: Efficiency Manon Cuylits Here, we might think an allocation such as y is not efficient, because it’s not on the contract curve, but actually, it is efficient (same for x and z that are on the contract curve). The contract curve = the maximum utility we can give to Alice or Bob How do you compare the utilities of different persons? It’s a tricky question. We’ll look at the social indifference curves (SIC). If we have the utility of A and B, we have the same satisfaction, so the same W. Each curve is a social difference curve and The map = the social indifference curves 6 Tools: Utility possibilities curves (UPC) and social indifference curves (social welfare functions). Social indifference curves (SIC) and Here we see the utility possibilities curves: • The utility is maximal for Alice if you give everything to Alice • The utility is maximal for Bob if you give Bob everything social welfare functions (SWF): 푊 = 푓 푈!"#$%,푈!"# 푤푖푡ℎ 푈!"#$% 퐹,퐷 푎푛푑 푈!"#(퐹,퐷) Social welfare framework = social welfare functions: you have to decide for everyone. If you look at people in terms of their utilities, you have to take some decisions to allocate the resources, then you have to aggregate so you have the utilities of everyone. Satisfaction can come from the fact you’re wearing nice clothes, driving a nice car etc. but it could also come from the fact you look at nice landscapes, etc.
  • 7. Public Economics 2013-­‐2014 Topic 3: Efficiency Manon Cuylits Here, you look at the utility of everyone (the utility of Bob and the utility of Alice) and then you try to find one number: W. This number will depend on what you put in the utilities of Bob and Alice (cars, etc.). Then you can decide to do something else: You could decide you’d like people to be more taking care of older people, etc. 7 è you search for the greatest/highest W. More on social welfare functions: two extreme cases ♥ Utilitarianism: W = U1 + U2 + … + UN ♥ Maximin criterion: W = min (U1 + U2 + … + UN) Half-­‐half B has some utility and A has none: A is starving Le maximin = maximiser le sort de la catégorie la plus défavorisée, le sort de ceux qui ont le moins. Level of utility: Here we could decide to give all the utility to A or all the utility to B, or to be just in the middle: half-­‐half Here we take the minimum within all the utilities of all the people (John Rawls): We look at the poorest person. If we want to raise the social welfare, we have to raise the satisfaction of the poorest person, so we have to allocate more resources to the poor people.
  • 8. Public Economics 2013-­‐2014 Topic 3: Efficiency Manon Cuylits 8 Choice of the fair (and efficient) allocation: 5. The second fundamental theorem of welfare economics The second fundamental theorem of welfare economics: “Any Pareto efficient allocation can be attained by making a suitable assignment of initial endowments2 and letting people trade with each other”. Hence, interventions on market themselves is not necessary, redistributing income is enough. Initial endowment: If we start from such an allocation and let the market work, Alice will give some of her drinks to Bob, in exchange with Bob’s food, so Alice will have fewer drinks and more food, and Bob will have more drinks and less food than at the beginning. Here we let the market work, we just have to redistribute endowments. The government redistributes income mainly through thanks to taxes: they redistribute through the tax system. 2 Dotation initiale If I’m a social planner, I will look at all these curves and chose the level at which the utility is the highest. Here we have: ♥ The utility possibilities curve ♥ The indifference curves The point where curves meet is more efficient that the rest of the utilities curves. This is the point where this is the best at the society point of view.
  • 9. Public Economics 2013-­‐2014 Topic 3: Efficiency Manon Cuylits Redistribution of initial endowments 9 GDP = Gross Domestic Product = what is produced in a year. Half of the GDP is subject to taxes. The government has the power to take half of the GDP and to redistribute it through various allocations (example: the fact that education is free until 18 years old, etc.). We really benefit from the money redistribution. The public intervention is really significant and powerful è the government taxes income, with higher taxes for people with higher revenues. The taxes are not proportional taxes but progressive taxes: if we have an income of 10, we will pay 1 of taxes, but if we have an income of 100, we will pay more than 10 of taxes. Equity-­‐Efficiency trade-­‐off Problem: government needs some way to reallocate resources and those mechanisms usually induce inefficiencies (e.g. income tax) Thus, in practice, there is to some extent a trade-­‐off between efficiency and equity. The 3 main ways to collect money = ♥ VAT ♥ Tax income ♥ … When we use tax income to collect money, people that are working know they will have much less than what they have truly earned while working. It does not encourage them to work much. It’s the same for VAT, if someone likes something, the fact he has to pay VAT when he buys it is a disincentive event. The government has to find a way to deal with that problem of disincentive events. è When we have a tax system, we need to create efficiency because the tax system creates a disincentive. If we want to move from an allocation we think is not fair because Alice has everything and Bob has nothing, if we do not move ON the curve, we lose some efficiency.
  • 10. Public Economics 2013-­‐2014 Topic 3: Efficiency Manon Cuylits 10 Excess burden of taxation: the window tax example 1696-­‐1851: “when the window tax was introduced, it consisted of 2 parts: • A flat-­‐rate house tax of 2 shillings per house and • A variable tax for the number of windows above ten windows. Properties with between ten and twenty windows paid a total of four shillings, and those above twenty windows paid eight shillings”. è Depending on the number of windows we had on our house, we had to pay more or less taxes. This could create a disincentive to having windows. This was not the purpose of having such a taxation system. 6. Conditions under which markets do not lead to efficiency Back to the first fundamental theorem of welfare economics: possible market failures. • Imperfect competition: Imperfect competition arises when agents have the ability to influence the price of a commodity (monopoly, oligopoly, product differentiation, etc.) It leads to prices above marginal costs or above marginal productivity. Conditions for efficiency are violated. For example, in the case of monopolies, prices are above the marginal cost: it means companies are capturing rents, they could produce more, so it’s not efficient. Ex: the electricity market: there are some measures taken on the concentration of producers, it has an impact on the price. • Asymmetric information: Asymmetric information is present when a party engaged in an economic transaction has better information about the good and service traded than the other party. Ex: insurance against the possibility of becoming poor. Everyone doesn’t know the same things. Ex: social security -­‐ example of a public intervention: there’s asymmetric intervention. In Europe, we have a social security system very well developed compared to other countries. Many people will have the possibility to be insured (private insurance); however, many people don’t have the possibility to be insured because they are too poor and, moreover, it’s not efficient, it is not covering all the sorts of disease. There’s asymmetric information between the doctor and the patient for example. • Public Good: A public good is a good that is non-­‐rival and non-­‐excludable in consumption, for example the roads. è Un bien public est un bien que chacun peut consommer en même temps, en même quantité et dans sa totalité. On ne peut pas exclure quelqu’un de l’accès à ce bien (non-­‐ excludable), si quelqu’un utilise ce bien, cela n’empêche personne de l’utiliser aussi (non-­‐rival), et au niveau de la production, le cout marginal = 0, cela veut dire que pour une personne supplémentaire utilisant ce bien, le cout est nul, cela ne change rien qu’une personne en plus utilise la route par exemple. • Externalities: An externality is an activity of one entity that affects the welfare of another entity in a way that is outside the market. Ex: airplane noise pollution.
  • 11. Public Economics 2013-­‐2014 Topic 3: Efficiency Manon Cuylits On parle d’externalités dans une situation économique ou l’acte d’un agent influe positivement (externalités positives) ou négativement (externalités négatives) sur la situation d’un autre agent non-­‐impliqué dans l’action, sans que ce dernier ne soit totalement compensé ou n’ait à payer pour les dommages et bénéfices engendrés. Exemple d’externalités négatives : la pollution Public goods and externalities are dealing with the existence of public goods and the fact that we have externalities. When there are public goods, the market will never be efficient. NB: in asymmetric information, public good and externalities, markets are missing. 11 7. Conclusion Two criteria to evaluate the state of an economy (an allocation of resources): • Efficiency (Pareto efficiency): no waste • Equity/fairness: social welfare function approach “Role” of markets: Competitive markets lead to efficiency when there is a market for each and every commodity (i.e. no imperfect competition, no public goods, no externalities). Role of a government: • Enhance efficiency: deal with market failures (imperfect competition and missing markets) and minimal role of property right protection • Enhance equity: deal with distributional issues Possible trade-­‐off between efficiency and equity. Appendix 1: a note on social choice How do we, as society, choose a (desired) point along the UPF3? We need a “social choice function (SCF)”, an ordinal ranking of the alternatives. • What criteria should such a function have? • How do we choose which function is the right one? A social planner is a kind of cop. How do we decide what to do? We do vote/elect politicians. They have programs regarding intervention on the market. They are writing laws intervening on the economy: the allocation of resources includes fiscal instruments è they do define a program with more taxes on companies, more redistributions, etc. for example. è The way those things (programs) take place in reality = through democracy, etc. 3 Utility Possibility Frontier
  • 12. Public Economics 2013-­‐2014 Topic 3: Efficiency Manon Cuylits 12 Arrow’s impossibility theorem (no question at the exam) • Pareto principle: “If at least one individual prefers option x to option y and no one strictly prefers y to x then society prefers x to y” • Universal domain: The SCF should work for any set of individual preferences (no matter how weird). • Non-­‐Dictatorship: The SCF should not depend solely on the rankings of one individual • Independence of irrelevant alternatives: The ranking of x and y should only depend on individual rankings of x and y and not on the preferences of individuals over x and z (nor y and z). Arrow: Any SCF should be complete and transitive and satisfy these four criteria. However, no SCF can satisfy these four criteria Condorcet’s Paradox (as an illustration of Arrow’s impossibility theorem) Rankings of alternatives, example • Liberals: Green Park > Public housing > Private housing • Labour: Public housing > Private Housing > Green Park • Conservatives: Private Housing > Green Park > Public housing Consider majority rule as a “social choice function”: When considering two policies, select the one that more people prefer. This will satistfy PUDI. But in the case above, the choice will depend on the way these are paired (as in Rocks-­‐ Paper-­‐Scissors). “Society prefers” Green Park to Public housing, Private housing to a Green park, and Public housing to Private housing. è Social preferences are not transitive. Appendix 2: Pure exchange economy • 2 goods: Food and Drink • 2 people: Alice and Bob Note: results hold for many people and commodities è The Edgeworth box:
  • 13. Public Economics 2013-­‐2014 Topic 3: Efficiency Manon Cuylits Each point is a basket of goods (food and drinks). 13 Alice Bob è Together A possible initial location Same level of satisfaction for any basket on a given indifference curve.