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- 1. Efficiency and Equity – Issues of Distributive Justice <ul><li>Much of the discussion so far has focussed on (Pareto) efficiency </li></ul><ul><li>Government policy can: </li></ul><ul><ul><li>Impact on the efficiency with which goods are produced </li></ul></ul><ul><ul><li>Impact on the distribution of resources across members of society </li></ul></ul><ul><ul><ul><li>Lottery </li></ul></ul></ul><ul><ul><ul><li>Agricultural price support programmes </li></ul></ul></ul><ul><ul><ul><li>Income tax </li></ul></ul></ul><ul><ul><ul><li>… .. </li></ul></ul></ul>
- 2. Possible reasons for government intervention <ul><li>Concerns about “distributive” justice </li></ul><ul><ul><li>cf. Egalitarian, utilitarian, Rawlsian…. </li></ul></ul><ul><li>Market Failure: </li></ul><ul><ul><li>Public goods (non-rival, non-excludable) </li></ul></ul><ul><ul><li>Information and transaction costs </li></ul></ul><ul><ul><li>Coordination failure (ie difficulties arising in bargaining) </li></ul></ul><ul><ul><li>Externalities </li></ul></ul><ul><ul><li>assymmetric information </li></ul></ul><ul><li>merit goods </li></ul><ul><ul><li>goods that society believes everyone should have (whether they want it or not) eg. education, health. </li></ul></ul>
- 3. Positive v Normative economics <ul><ul><li>positive economics is concerned with identifying the logical outcomes which follow upon a set of underlying assumptions. Eg. demand for a good can be derived from utility maximisation. </li></ul></ul><ul><ul><li>normative economics deals with whether particular outcomes are desirable or not, it may involve comparing different outcomes and trying to reach a judgement as to which is preferable welfare economics </li></ul></ul><ul><ul><li>welfare economics involves the ethical appraisal of economic systems </li></ul></ul><ul><ul><ul><li>welfare economics involves making judgements comparing the desirability of one situation in comparison to another. </li></ul></ul></ul><ul><ul><ul><li>Such judgements are inevitably normative. </li></ul></ul></ul><ul><ul><ul><li>One way of trying to avoid normative debate is the Pareto Criterion </li></ul></ul></ul>
- 4. At General Equilibrium 3 conditions hold: <ul><li>1) Efficiency in distribution: If the MRS between the two goods is equal, then the goods have been optimally allocated among the consumers </li></ul><ul><li>2) Efficiency in factor substitution: If the MRTS between the two factors is equal for all firms then the factors have been optimally allocated between firms </li></ul><ul><li>3) Efficiency in product-mix : If the MRS and MRPT are equal for the two goods then we have the optimal composition of output in the economy, and the optimal allocation of resources. </li></ul><ul><li>Note that “optimally” here is a positive statement (ie most efficiently), and not a normative statement </li></ul>
- 5. Fundamental Theorems of Welfare Economics <ul><li>1 . First Theorem : where there is a perfectly competitive equilibrium the allocation of resources will be Pareto optimal </li></ul><ul><ul><li>ie if the MRPT = MRS A = MRS B </li></ul></ul><ul><li>2. Second Theorem : any Pareto optimal allocation of resources that is logically feasible can be arrived at via competitive markets, provided that the economies’ initial endowment of resources can be redistributed in an appropriate fashion </li></ul><ul><ul><li>ie that any of the Pareto efficient points are in principle attainable by the economy - “all” that you need to do is to redistribute endowments in an appropriate fashion </li></ul></ul><ul><ul><li>appropriate fashion means in a non-distortionary fashion ie in a way which is unrelated to agents’ market activites. This means that taxes and transfers should be lump-sum </li></ul></ul>
- 6. The Pareto Criterion <ul><li>“ if when the resources available to society are reallocated among alternative uses, the economic welfare of a least one member of society is increased without that of another member being reduced, than the economic welfare of that society has increased” </li></ul><ul><ul><li> Pareto optimality is where it is impossible to reallocate resources in order to increase the economic welfare of one individual except at the expense of another </li></ul></ul><ul><ul><li>There are many possible Pareto efficient outcomes </li></ul></ul><ul><ul><li>Involves key value judgements: </li></ul></ul><ul><ul><ul><li>Process independence: ie ignores the process by which final allocations are arrived at (planned economy v free mkt) </li></ul></ul></ul><ul><ul><ul><li>Individualism: focus is on welfare of individuals. </li></ul></ul></ul><ul><ul><ul><li>Non-paternalism:judgements made on the basis of individuals’ own utlity functions and not on the basis of a third party’s judgement (eg. Seat belt, smoking…) </li></ul></ul></ul><ul><ul><ul><li>Benevolence… to every individual in society. If anybody’s utility is improved than societies’ welfare goes up irrespective of who that indivicual is. </li></ul></ul></ul>
- 7. The Pareto Criterion <ul><li>Seems “reasonable” however: </li></ul><ul><ul><li>identifies societies’ welfare with the welfare of the individuals making up the society, and not with particular groupings </li></ul></ul><ul><ul><li>doesn’t inform us as to how much better one situation is over another </li></ul></ul><ul><ul><li>doesn’t help in comparing two policies both of which might be Pareto improving </li></ul></ul><ul><ul><li>in particular says nothing about the distribution of welfare between individuals </li></ul></ul><ul><ul><li>moving from a Pareto sub-optimal situation to a Pareto optimal situation might make someone worse off </li></ul></ul>
- 8. Figure 10.4 Contract Curve a g Both a and g are on the contract curve -- we cannot rank these allocations using the Pareto rule!
- 9. <ul><li>Re. the First Welfare Theorem: “ where there is a perfectly competitive equilibrium the allocation of resources will be Pareto optimal” </li></ul><ul><li>Suppose P Y is above the perf. comp. price due to either monopoly power or taxes. </li></ul><ul><li>The economy is producing “too little” Y, and “too much” X. </li></ul><ul><li>MRT P x /P y =MRS </li></ul>0 Y e X e Y X
- 10. <ul><li>Re. the First Welfare Theorem: </li></ul>0 Y e X e Y X <ul><li>Now suppose the distortion is removed, and prices adjust </li></ul><ul><li>A new equilibrium is possible where at least one consumer is better off, and the other is no worse off, or indeed, where both are better off. </li></ul><ul><li>So this would satisfy the Pareto Criterion </li></ul>
- 11. 0 Y e X e Y X <ul><li>But it is also possible that with the distortion removed: </li></ul><ul><ul><li>B is on a higher (red) indifference curve </li></ul></ul><ul><ul><li>A is on a lower (green) indifference curve. </li></ul></ul>
- 12. Compensation & potential Pareto improvements <ul><li>If the Pareto criterion does not enable us to choose, can we solve the problem by appropriate compensation payments? Hicks-Kaldor: </li></ul><ul><ul><li>A move from one situation to another would be desirable if those who gain from the move were able to compensate the losers, and still remain better off themselves. </li></ul></ul><ul><ul><li>Also it should not be possible for the losers to bribe the gainers not to make the move . </li></ul></ul><ul><li>The underlying idea here therefore is that of a Potential Pareto Improvement </li></ul><ul><li>In order to see this need to consider utility possibility frontiers, and social welfare functions… </li></ul>
- 13. UPFs and SWFs <ul><li>Utility possibility curve: the set of utility levels corresponding to the Pareto efficient allocations along the contract curve. </li></ul><ul><ul><li>Note that Perloff refers to this as the Utility Possibility Frontier. See below for a better explanation / definition of this . </li></ul></ul><ul><li>The UPF is then defined as the maximum possible utility derived from all the possible UPCs </li></ul><ul><li>A social welfare function aggregates various consumers’ utilities to provide a collective ranking of allocations (but this aggregation would be possible only if everybody same preferences). It expresses preferences of society over resource distribution. </li></ul>
- 14. 0 A Y X 0 B U B U A Edgeworth Consumption Box Utility possibility curve : derived by moving along the contract curve. a b a b <ul><li>As B’s utility , A’s utility </li></ul><ul><li>as we are dealing with ordinal utility we cannot say by how much </li></ul><ul><li>so the curve slopes downwards but not at a defined rate </li></ul>
- 15. <ul><li>There is a new consumption contract curve for each point on the PPF, so there is a different utility possibilities curve (UPC), for each point on the PPF </li></ul><ul><ul><li>eg. moving from equilibrium 1 to equilibrium 2. </li></ul></ul>0 Y e X e Y X 1 2
- 16. <ul><li>There is a new consumption contract curve for each point on the PPF, so there is a different utility possibilities curve (UPC), for each point on the PPF </li></ul><ul><li>Suppose we move from equilbrium 1, to equilibrium 2. </li></ul>U B U A d 1 2 <ul><li>If we were originally at d , and then moved to somewhere between e & f then the move is desirable from a Pareto point of view. </li></ul> <ul><li>In the move from d to g , the gain in welfare for B is b 1 -b 2 ; the loss of welfare for A is a 1 -a 2 </li></ul><ul><li>B could compensate A for their loss (by moving from g to e ), and still be better off themselves - so the move is desirable </li></ul><ul><li>A could not bribe B, to stay in the original situation, so one cannot say that the move is not desirable </li></ul><ul><li>But we cannot say that g is welfare superior to d </li></ul>g e f b 1 a 1 b 2 a 2
- 17. <ul><li>Suppose we move from policy 1 to policy 2, which involves a move from d to g. </li></ul><ul><ul><li>As a result of that move B is better off while A is worse off. Hence B wants policy 2, while A prefers policy 1. </li></ul></ul><ul><li>Consumer B can bribe A to accept policy 2, by offering a move from g to f . </li></ul><ul><ul><li>At f consumer A is as well off as under policy 1, while B is better off </li></ul></ul><ul><li>However, from G, consumer A, could bribe consumer B to revert to policy 1, and move to point e . </li></ul><ul><ul><li>at e consumer B is as well off as under policy 2, while A is better off. </li></ul></ul>U B U A 2 1 But the UPC’s can intersect... e f d g <ul><li>Hence the compensation criteria give conflicting outcomes </li></ul>
- 18. U B U A The Utility Frontier <ul><li>The utility frontier shows the maximum amount of utility B can attain, given the utility available to A, where fixed quantities of factors of production are available to be reallocated between the production of various goods. </li></ul><ul><li>Every point on the frontier is Pareto optimal. </li></ul><ul><li>Without making judgements about the distribution of income we cannot determine where on the frontier we should be </li></ul>The movement from a to b represents a change in the two individuals’ utilities + a reallocation of resources with the output mix changing b a
- 19. Figure 10.9a Welfare Maximization UPF c a b (a) Jane ’ s utility W 1 W 2 W 3 Denise’s utility Isowelfare curves: (similar to individual indifference curves) summarise all the allocations with identical levels of welfare. Their shape reflect different views of society about distribution UPF: derived by moving along the contract curve. Ordinal utility, so we cannot say how much the curve slopes downwards but not at a definite rate
- 20. Figure 10.9a Welfare maximization UPF c a (a) Jane ’ s utility W 1 W 2 Denise’s utility Y Assuming it is possible to construct this type of functions, this representation nicely illustrates the conflict between efficiency and equity X
- 21. Different approaches to distributive justice <ul><li>Market-based </li></ul><ul><ul><li>Each person should be rewarded based on her contribution. Merit-based, not needs-based. Efficient is also ‘just’ </li></ul></ul><ul><li>Egalitarianism </li></ul><ul><ul><li>All individuals should have same utility levels </li></ul></ul><ul><li>Utilitarianism </li></ul><ul><ul><li>maximise the sum of the utilities of all members of society. Utilities of all people typically given equal weight </li></ul></ul><ul><li>Natural Right (Nozick) </li></ul><ul><ul><li>based on the notion that the “process” matters </li></ul></ul><ul><li>Rawls </li></ul><ul><ul><li>Resources should be redistributed so to maximise the well-being of the worst-off member of society </li></ul></ul>

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