Part IIa: Paper 1

Dr Snje
j Reiche
i h
Part 4

Motivation
Casual use of Social Indifference curves
Where do these come from?
How are the interests of different individuals weighed up in
creating such social indifference curves?

With trade, some winners and some losers

Want
W a mechanism
h i for
f evaluating
l i policy
li

N
Normative
ti issues
i
(rather than positive analysis of GE)
2

Outline: Welfare Economics

Concepts of Welfare Economics

Basic Value Judgements
Bergson-Samuelson Social Welfare Functions
Utilit i i vs Rawlsian
Utilitarianism
R l i SWF

Books
Varian Ch. 33
Cowell Ch. 9.1, 9.4, 9.5

Concepts of Welfare Economics

Want social preference ordering over states
complete (defined over all states)
transitive

xf y
yfz
xfz

Less controversial at individual level, but what does

this imply at society level?
4

 Distinguish:
g

Bergson-Samuelson Social
Welfare Function

S
Social
i l welfare
lf function
f ti (which
( hi h corresponds
d to
t
individual utility function)
Mechanism for achieving this social welfare
function (through combining individual
preferences)
Arrow:
Social Choice Rule,
Social Welfare Functional
or
5
Constitution

Basic Value Judgements

Individualism
1
1.

Resource allocations
R
ll
i
should
h ld be
b judged
j d d only
l through
h
h their
h i
effects on individuals in the economy

Society is a collection of individuals

Goal of government is to achieve well-being of the individuals
who compose society
Individual rights crucial for well-being

JJohn
h L
Locke
k (1632-1704),
(1632 1704) Adam
Ad Smith
S i h (1723-1790),
(1723 1790) JohnJ h
Stuart Mill (1806-1873)
6

Non-Paternalism
2. Individuals are the best judges of their own
welfare

The effects of different resource allocations on an

i di id l depend
individual
d
d only
l on that
h individuals
i di id l preference
f
orderings

Alternative: Society
y as an Organism
g
Plato (424-348 BC), Karl Marx (1818-1883)
Thomas Hobbes (1588-1679)
Rulers determine goals for the organism (e.g.
q
, glory
g y of God,, triumph
p of ideology)
gy)
conquest,
Individuals matter only insofar as they can be used
as tools to achieve those goals
II.e.,
e A heart muscle cell has no independent
importance beyond helping pump blood
Examples: Divine right of kings: Britain (formerly!)
Communism
Fascism
8

Basic Value Judgements

Pareto Principle
Allocation Y is socially preferred to allocation Z if Y is feasible
given resource constraints, all individuals are at least as well off
in Y as in Z,
Z and at least one individual strictly prefers Y to Z.
Z

I li it Assumptions
Implicit
A
ti
Individualism and Non-Paternalism
Process Independence
Anonymity
9

Implications

Define a utilityy function to represent

p
an individuals
preferences over resource allocations

This is an ORDINAL utility function

1.

Ordinally measurable

2.

utilityy numbers for an individual convey

y information about that
individuals welfare BUT only convey information on the order,
not intensity

Noncomparable (across individuals)

utility numbers generated by different individuals

individuals utility functions
cannot be compared
10

Key: an ordinal
K
di l utility
ili function
f
i is
i unique
i
up to a positive,
ii
monotonic transformation
u1a = xy
u1b = log x + log y
u1c = x 3 y 3
all represent the same preferences
The units have no meaning: convey no information about the
i t it off individual
intensity
i di id l 1s
1 preference
f
Hence, the units used for individual 1 convey no information that
Hence
can compare utility to individual 2s level of utility
11

Utilityy Possibilityy Set

Different resource allocations between person 1 and 2 lead to different
utility levels for each (mapping from contract curve into utility space)
Pareto principle

u2

Allows comparison between some

allocations (A and B)
Not between others (A and C)

C
B
A

INCOMPLETE ORDERING
BUT: Pareto improvement possible
f
from
interior,
i
i so necessary condition
di i

u1
(although precise shape of UPS depend on the particular representation)

12

Compensation Tests
Cannot rank Pareto efficient allocations
defines set of all efficient allocations

Need additional criteria (if equity matters)

One allocation is more desirable than another if the gainers could
hypothetically compensate the losers and still be better off
(potential Pareto improvement)
Uses willingness to pay (idea of CV): consider a price movement
from p to p
v( p ' , m CV ( p, p ' )) = v( p, m)
13

Compensation Tests
Take x and y with u1 ( x) > u1 ( y ), u 2 ( x) < u 2 ( y )
Ask: How much would 1 (and 2) be willing to pay (accept) in
terms of monetaryy compensation
p
to gget x instead of yy?
If CV1 ( y, x) + CV2 ( y, x) > 0 individual 1 can compensate 2
for ggettingg x rather than yy. Can sayy that x is better than yy.
No need for interpersonal value judgement!
But:
Only hypothetical reallocation. Otherwise: real pareto improvement.
Implicit assumption that value of 1 is worth the same to all
individuals (so it does not matter who actually benefits).
Can lead to Paradox: Both x and y can p
pass the compensation
p
test.
New test: CV1 ( y, x) + CV2 ( y, x) > 0 and CV1 ( x, y ) + CV2 ( x, y ) < 0 ?
14
Criterion is not transitive!

Bergson-Samuelson
g
Social Welfare
Functions
Criteria to rank different allocations using explicit distributional
value judgements (i.e. degree of concern for equity)
Benevolent
B
l t social
i l planner,
l
defines
d fi
preference
f
ordering
d i using
i
particular utility representation of individual preferences

W (x ) = W (u1 (x ), u 2 (x ),..., u N (x ))
xf y
if andd only
l if
W (x ) > W ( y )

Cardinal
C
di l utility
tilit
function!
15

P
Properties
ti
W
0
uh

Paretian

Anonymous: identity of individual does not matter

Weak preference for equality (quasi-concave)

u2

u1

16

Forms of B
B-S
S SWF: Utilitarianism
N

W = u1 + u2 + ...+ uN = uh
h=1

Utility of 1 is a perfect substitute for the utility of 2

u2

u1
This does not imply that giving 1 to individual 1
has the same benefit as giving 1 to individual 2

17

Forms of B-S SWF: Rawlsian

Maximise the welfare of the worst off person in society

W = min [u1, u 2 ,..., u N ]

u2

u1
Utilityy of individual 1 is a pperfect
f complement
p
for the utilityy of
individual 2
18

B-S SWF
Basis for showing how attitudes to inequality affect optimal allocations

u2

Utilitarian

R li
Rawlsian

45

Egalitarian

UPF

u1

19

Summary
Evaluation of value to society of different allocations
Individualistic
I di id li ti
Pareto

Pareto does not provide complete ranking

Compensation criterion: potential Pareto, implicit equal
weight
g
Bergson-Samuelson:
g
compares
p
across individuals
20

Outline: Arrow

Definition
Desirable Properties
Three possible resolutions of impossibility!
Focus on information requirements for individual
utility
tilit functions
f ti

Books:
Varian: Ch. 33
Cowell: Ch. 9.2

21

Arrow (1951): Social Choice Rule

Where does Bergson-Samuelson
g
Social Welfare function come
from?
how does society aggregate individual preferences into a social
ordering?

Function of cardinal and individually

comparable utility values
B-S SWF: mechanism for making decisions about which
allocation is optimal given social preferences about inequality
Function of individual
preference orderings
Arrow Social Choice Rule: is there a function (or rule) which
generates these social preferences?
((Social Welfare Functional or Constitution))
22

Example
p
3 Individuals in society, 3 alternatives A, B, C:
Preferences are given by
Af Bf C
1

B 2 C f 2 A
C f 3 A 3 B
Utility representation:
u1 (A) = 8
u2 ((A)) = 7

u1 (B) = 6,
u2 ((B)) = 280

u3 (A) = 5

u3 (B) = 5

u1 (C) = 1
u2 ((B)) = 280
u3 (C) = 4

23

Example:
Utilitarian B-S SWF

Arrows SCR,
Example

W ( A)) = W ((8,7,5)
, , ) = 4
W (B) = W (6,280,5) = 281
W (C) = W (1,280, 4) = 283

Bf AfC

24

Desirable properties of a Social Choice Rule F

1.

Universality (unrestricted domain) [U]

2.

F must be
b defined
d fi d over all
ll possible
ibl sets off iindividual
di id l preference
f
orderings

Pareto principle
i i l [P]

3.

if all individuals prefer allocation Y to Z, then social preference

ordering must rank Y above Z

Independence of irrelevant alternatives [IIA]

4.

the social preference of Y compared to Z depends only on individual

orderings of Y and Z and does not depend on other orderings of other
allocations

Non-dictatorship [ND]

there is no individual whose preference ordering determines the

social preference ordering
25

E ample continued
Example
contin ed
In the Example: There are 63=216
216 strict preference
ordering profiles
A f1 B f1 C

A f1 B f1 C

A f1 B f1 C

A f1 B f1 C

A f1 B f1 C

A f1 B f1 C

B f2 C f2 A

B f2 C f2 A

B f2 C f2 A

B f2 C f2 A

B f2 C f2 A

B f2 C f2 A

A f3 B f3 C

A f3 C f3 B

B f3 A f3 C

C f3 A f3 B

B f3 C f3 A

C f3 B f3 A

ordering
gI

g III orderingg IV orderingg V orderingg VI

orderingg II ordering

CCX more!
26

Universality
The Social Choice Rule must map each set of preference
orderings
d i
i
into
a social
i l ordering
d i over the
h 3 alternatives,
l
i
for
f
example:
F ( I ) = F ( II ) = F ( III ) = F ( IV ) = { A f B f C }
F (V ) = F (VI ) = {C f A f B}

until
til F(CCXVI)

Pareto Principal
The SCR that sets F ( III ) = {C f A f B} violates [P].
Test: Does [P] say anything
hi about
b
F(IV)?
( )

27

Independence of Irrelevant Alternatives

The way in which F(I),
F(I) F(III) and F(V) rank B and C
must be the same!
Test: If F(II) ranks A over B,
B can we conclude that
F(III) must also rank A over B? What about F(IV)?

Non-Dictatorship
Non
Dictatorship
The SCR that sets F f 2 violates [ND].
I:

A f1 B

II:

A f1 B

III:

B f1 A

IV:

Test:
Af B
Bf A
Af B
What possible SCRs satisfy all 4 requirements?
2

B f1 A
B f2 A

Impossibility Theorem

In general, does there exist a social choice rule, F,

th t satisfies
that
ti fi these
th
4 desirable
d i bl requirements?
i
t?

Arrow: With more than

A
th
2 alternatives: No!

Needs to generate a social preference ordering from

individual preference orderings

ordinal utility / ordinal social welfare

29

Majority Voting as the Social Choice Rule?

1 : a f1 b f1 c
2 :b f2 c f2 a
3: c f3 a f3 b
Condition U: satisfied for all admissible ppreferences
Condition P: would be satisfied!
Conditions IIA and ND satisfied if social choice between any
pair of allocations is made by majority voting between that pair

afb
bfc
cfa

not transitive
30

Solutions to Impossibility
Relax universality
Majority voting
works if single-peaked preferences
difficulties if multi-dimensional preferences

Relax independence of irrelevant alternatives

Impose
p
some cardinalityy of utilityy

31

Single-peaked preference
For each individual
there is a uniquely
optimal policy. The
closer a policy is to
the optimal policy the
higher it is ranked.

utility

toptimal

tariff

32

Single-peaked
Single
peaked preferences
utility

capitalists

Median voter always

votes with the
majority

land owners

workers

t t

tariff

33

Whatss wrong with:

What
1 : a f1 b f1 c
2 :b f2 c f2 a

3: c f3 a f3 b

Individual 3
does not have
single peaked
preferences!
f
!
a

c
34

Relaxing IIA
First
First-past-the-post:
past the post: largest number of votes wins

adding extra competitors affects the result (Ross Perot

in US, Le Pen in France)

Example :

A f1 B f1 C

A f1 B f1 C

A f2 B f2 C

C f2 A f2 B

B f3 A f3 C

B f3 A f3 C

C f4 B f4 A

B f4 A f4 C

A
B
1. Individuals rankings between A and B are the same in
the two sets but the social ordering changes
2 C is a competitor who is never elected but his presence
2.
35
affects the election between A and B.

Relaxing IIA
Borda voting: assign a score to each alternative, (1 to
worst, 2 to next etc.),
) add upp scores and rank alternatives
according to the total.
particular point system matters (eg.
(eg 1,
1 2,
2 4,
4 8 instead)
discarding the worst and recalculating may affect the
outcome
A f1 B f1 C
A f2 B f2 C
B f3 A f3 C
C f4 B f4 A

(1,2,3)
A=9

(1,2,4)
A = 11

B=9

B = 10

C=6

C =7

ABfC

Af BfC

discarding C :
A=6
B=6
AB
36

Imposing Cardinality
The only information for each individual allowed
b Arrow
by
A
iis an individuals
i di id l preference
f
ordering
d i
Corresponding utility functions are
ordinallyy measurable
non-comparable
[ ONC ]

37

C id the
Consider
th B-S
B S SWF with
ith ONC utility
tilit information
i f
ti
1 N
u = uh
N h=1

1
W = u + min
i (uh u ),
2

Will the B-S SWF remain unchanged as individual utility is

transformed?

Allocation Y Allocation Z
u1

u2

4 1/2

5
38

Transform individual utility (preserving individual preference

ordering):

)
u1 = 0.5u1
)
u2 = 4u2

u1

Allocation
Y
2

Allocation
Z
4

u2

24

16

7 1/2

Social ordering is not invariant to (permissible)

transformations of utility

39

Relaxing ONC
What extra measurability and comparability assumptions are
necessary to resolve Arrow?
Suppose individual utility:
cardinally measurable for each i

)
ui = i + i ui

i > 0

fully comparable across i (same transformation has to be applied to all

individuals)

)
ui = + ui

> 0, i

Social choice rule exists and satisfies all 4 conditions: need extra
information on intensity and comparability
40

Cardinally measurable for individual i: The difference

b
between
utility
ili levels
l l for
f iindividual
di id l i has
h meaning
i
Take alternatives x, x, y and y.
If the difference in utility between x and xx is 5 times bigger
than the difference in utility between y and y, this is true for
any cardinal utility representation of i s preferences.

ui ( x) ui ( x' ) i ui ( x) + i i ui ( x' ) i ui ( x) ui ( x' )

=
=
ui ( y ) ui ( y ' ) i ui ( y ) + i i ui ( y ' ) i ui ( y ) ui ( y ' )
Comparable across individuals:
Take alternatives x, x
If the difference in utility between x and x is 5 times bigger
for i than for j, this is true for any utility representation of i
and js ppreferences.

ui ( x ) ui ( x ' ) ui ( x ) + ui ( x ' )
ui ( x) ui ( x' )
=
=
u j ( x) u j ( x' ) u j ( x) + u j ( x' ) u j ( x) u j ( x' )

Summary
Arrow: how are individual preference orderings aggregated to
give society
societyss preference ordering?
Impossible under minimal assumptions (U,P,IIA,D)
(U P IIA D)
Limited information on individual preferences: only ordinal
information, so no intensity or comparability
Extra information enables aggregation to B-S SWF
42

Outline: Efficiency and Equity

Conditions for Pareto Efficiency
First
st Fundamental
u da e ta Theorem
eo e
Efficiencyy vs Equity:
q y The Second
S
Fundamental Theorem
Implications
p
of the SWT
First Best vs Second Best
Lumpp sum taxes
43

 Books:
Cowell Ch.
Ch 9.3-9.3.2,
9 3 9 3 2 13
13.7
7
Varian Ch
Ch. 31.9-31.13,
31 9 31 13 32.7-32.14
32 7 32 14

First Best and Second Best

First Best:
an allocation which is Pareto efficient subject only to
overall resource constraints and technology constraint

Second Best
an allocation
ll ti which
hi h is
i Pareto
P t efficient
ffi i t subject
bj t to
t resource
constraints and additional constraints (eg. imperfect
information)

45

First Best Pareto Efficiency

Nothing about prices in defining first-best allocation
All goods are private:
rivalrous (if one person consumes a good, this uses up the good and so
no one else can consume it)
excludable (one person can stop another from consuming the good)

Conditions for Pareto Efficiency:

Production efficiency
Consumption efficiency
Overall efficiency

46

Pareto Efficiency in a Simple Economy

Two goods, x and y, two inputs K and L in fixed supply
Two
T consumers A and
d B with
i h ui(x,y),
( ) i=A,B
i AB
Two firms with technology fj(K,L), j=x,y

max

x A , y A , x B , y B , K x , Lx , K y , L y

u A (x A , y B )

subject to

u B ( xB , y B ) = u B

f x ( K x , Lx ) = x A + x B

K = Ky + Kx

f y (K y , L y ) = y A + y B
L = L y + Lx

Production Efficiency
y
max

K x , Lx , K y , L y

f x (K x , Lx ) subject to:

f y (K y , L y ) = y
K = K y + K x ; L = L y + Lx

max f x (K x , Lx ) + y f y (K K x , L Lx )
K x , Lx

F.O.C.s

f y (K K x , L Lx )
f x (K x , Lx )
=
Ly
Lx
f y (K K x , L Lx )
f x (K x , Lx )
=
K y
K x

f K x , Lx
f K y , Ly
y
Lx

L
=
x
x
f K , L
f K y , Ly
K x
K y

48

Production Efficiency
Oy

x
y
MRTS KL
= MRTS KL

Potential allocation
of inputs

Area of Pareto
improvement

Ox

f K x , Lx
f K y , Ly
y
Lx

L
=
x
x
f K , L
f K y , Ly
K x
K y

49

Consumption Efficiency
OB

y
Area off P
A
Pareto
t
improvement

Potential allocation of
consumption goods
MRS xyA = MRS xyB

u
OA
u ( x , y ) u ( x , y )
B
x A

x
=
A
A
u ( x , y ) u ( x B , y B )
y A
y B
A

50

Putting them together

max u A ( x A , y B )

x A , y A , xB , y B

F.O.C.

u A
=0
x A
u A
+ F ' = 0
y A

subject to

u B ( xB , y B ) = u B
x A + xB = F ( y A + y B )

u B
=0
xB

u B

+ F ' = 0
y B

MRS xyA = 1 / F ' = MRS xyB

MRTxy

Overall Efficiency
y

MRTxy

Potential allocation for

economy

MRTxy = MRS xy
MRSxy

Area off Pareto

A
improvement

PPF

x
MRTxy = MRS xy
52

Fundamental Theorems of Welfare

Economics
Introduce prices: what are the welfare
properties of the market?
Assumption 1: Competitive Markets
Consumers and firms take prices as given
Consumers and firms optimise
p
Markets clear
53

Assumption 2: Complete Markets

Enforcability of contracts and complete allocation of
property rights
A market exists for all goods which influence either
individual utilities or firm production

No externalities
No
N public
bli goods
d
No asymmetries of information
54

(Aside on externalities)
Consumption externality

u A ( x A , y A , xB )

Assumption
i is
i NOT that
h this
hi sort off utility
ili function
f
i is
i ruled
l d
out
Rather
R th the
th assumption
ti is
i that
th t there
th is
i a price
i for
f eachh goodd
if there
th is
i a price
i (market)
(
k t) for
f eachh good,
d then
th the
th
externality becomes a pecuniary externality
55

First Fundamental Theorem

If assumption of complete and competitive markets
h ld then
holds,
th a generall competitive
titi equilibrium
ilib i
is
i
first-best Pareto efficient.
Intuition:
Optimising consumers each set :

px
MRS =
py
i
xy

So, if all
ll consumers face
f
the
h same prices,
i
then
h consumption
i efficiency
ffi i
Si il l with
Similarly
ith optimising
ti i i firms:
fi
eachh sets
t
Allocation of production between firms:

w
MRTS =
r
px
MRTxy =
py
j
KL

56

Caveats
Agents might not be price-takers if markets are
monopolized
li d or monopsonized
i d prices
i
do
d not
measure the marginal value of all activities.
Markets mayy not be complete:
p
how likelyy is it that
there is a market for clean air noise etc.? Future
markets,, markets for state contingent
g
commodities?

Equity vs Efficiency
FT1: market leads to the Pareto frontier
Pareto optimality: which point on the Pareto frontier
maximises
i i social
i l welfare?
lf ?
Is there a cost between moving to a point on the
frontier which improves social welfare? Is there a
trade off bet
trade-off
between
een efficiency
efficienc and equity?
eq it ?

58

Assumption 3: Convexity
Individual indifference curves are convex
rules out a preference for extremes (over mixtures)

Firm production sets are convex

rules out increasing returns to scale

(Assumptions necessary for existence of competitive

equilibrium)
q
)

59

Assumption 4: Ideal Lump-sum

Lump sum Taxes
With lump sum tax or transfer the receipt or payment of a sum
of money is independent of individual choices
Transfer based on an individuals endowment (individual
specific)
Key:
ey: imposition
pos o of
o a lump-sum
u p su tax leaves
e ves all individuals
d v du s
facing common prices
but those common prices may depend on the lump sum taxes because
of wealth effects

60

Assumption 4: Ideal Lump-sum

Lump sum Taxes
A tax on labour income is not lump-sum:
the price paid by the firm is different from that received by the worker
individuals
i di id l can change
h
their
th i tax
t burden
b d by
b changing
h i their
th i behaviour
b h i

61

Second Fundamental Theorem

If assumptions 1 to 3 hold, then any Pareto efficient
allocation
ll
i can be
b achieved
hi d by
b appropriate
i
redistribution through lump-sum taxes by leaving
the
h competitive
i i market
k to find
fi d prices.
i

Prices will depend on endowments and the extent of

redistribution
BUT all individuals face the same prices so no distortion to
Pareto efficiency
62

FT2 in an Exchange Economy

Competitive equilibrium
that maximises SWF
y

Competitive equilibrium,
no intervention
OB

e yA + e yB
SWF*

Initial
endowment

e2
OA

exA + exB

e1
x

To achieve SWF*, tax is imposed on individual As endowment, and this is

transferred to individual B in form of a transfer of good x (money)
Tax and transfer are lump-sum since value of endowment is taken as given63
by each individual

Non Convexity of indifference curves

Non-Convexity
OB

Nott supported
N
t d by
b
competitive equilibrium
prices

p
OA
P
Pareto
Effi
Efficient
i

S mmar
Summary
Necessary conditions for Pareto efficiency
First Welfare Theorem: competitive
p
market leads to Pareto
efficiency
S
Second
dW
Welfare
lf Theorem:
Th
any Pareto
P t efficient
ffi i t point
i t is
i achievable
hi bl
by LST and competitive markets
allows us to separate out efficiency from equity

65

Implications of FT2
Decentralisation result: redistribute with limited
government informational
i f
i l requirements
i
decentralised decisions will lead to a first-best Pareto
allocation
ll
i (satisfy
( i f the
h marginal
i l conditions)
di i )

Separate out equity from efficiency: any point on

the Pareto frontier can be achieved.
there is no conflict between redistribution and
achieving a first-best Pareto allocation
66

Implications

There are two distinct reasons for government

intervention (under
( nder the ass
assumptions
mptions of the FT2):
1 T
1.
To redistribute:
di t ib t competitive
titi market
k t may nott lead
l d to
t
the Pareto efficient point that maximises social
welfare
2. To correct market failure (due to failure of one of
assumptions 1 to 3)

to return to first best (eg use of Pigouvian taxes to correct

externalities)
67

Value of FT2
FT2 provides rationale for why government
i
intervention
i may be
b desirable
d i bl
Assumptions (particularly on information) are
veryy strong:
g
FT2 is not valuable to understand what form
interventions should take
second best analysis of policy intervention

68

First Best vs Second Best

Focus on FB vs SB for efficiency
y ((i.e. keep
p assumption
p
4 that
LST feasible)
Distortion to FB: there is one good where price does not equal
marginal cost (e.g. price of using a road is zero)
Competitive equilibrium will not be first best

MRS MRT
First best solution: is it possible to remove the distortion
directly? If so, then move back to the first best.
If not:
try to satisfy as many Pareto conditions as possible (i.e. ensure efficiency
in all other markets ignoring distortion )
or introduce offsetting distortion (second best policy)
69

Example

Car use (when congestion):

First best: directly price externality (road pricing set at

marginal cost imposed on others) Pigouvian solution

Second best: what is the price for public transport?

1.

private
social
pcar = MCcar
< MCcar

Price at marginal cost: public transport is at Pareto efficient level

private
social
p public
bli = MC public
bli = MC public
bli

2.

But cars and public transport are substitutes: price below marginal cost
induces switch away from car use
social
pcar MCcar

1 car user switches: saving of deadweight loss in car market,

social
imposes
p
deadweight
g loss in public
p
transport,
p , but negligible
g g
since p public = MC public

efficiency saving by introducing extra distortion 70

CAR USE
p

PUBLIC TRANSPORT

Deadweight
g loss
SMC

PMC
q*

Reduction in
deadweight loss from
marginal reduction in
q: MB - SMC

MC

p*
q*

Introduced
deadweight loss from
marginal increase in
q: (P-MC)
(P MC)
71

Information and LST

Redistribution requires lump sum payments to vary across
individuals according to their characteristics (e.g.
(e g
endowments of ability)
These characteristics are private information to the
individual. Government only observes behaviour.
Needs to be in interests of the individuals to reveal
information on characteristics through behaviour

Problem of incentive compatibility

p
y
72

Lump Sum Taxes and Incentive Compatibility

2 goods: coconuts c and leisure z
individuals endowed with H units of leisure
CRS technology: 1 unit of labour produces a units of coconuts
different types of labour: individuals of high ability, individuals of
low ability.
a >a
h

Identical preferences over c and z

u (c ) + v( z )
Assume v concave
73

Characterization of Pareto Efficiency

Assume government maximises a Utilitarian SWF, i.e., it
chooses consumption and leisure bundles for each person
subject to overall feasibility.

max u (ch ) + v( z h ) + u (cl ) + v( zl )

c h , cl , z h , z l

s.t. ch + cl = ah (H z h ) + al (H zl )
First-order conditions for consumption:

u (ch )
ch :
=
ch

u (cl )
cl :
=
cl

Equate marginal utility of consumption across individuals

With identical utility functions,
functions this implies identical levels of
consumption.

74

First-order conditions for leisure

v( z h )
zh :
= ah
z h

v( zl )
zl :
= al
zl

v( z h ) / z h ah
=
v( zl ) / zl
al
ah
>1
al

v( z h ) v( zl )
>
z h
zl

z h < zl

Same level of consumption

consumption, but high ability person works more
in the social optimum.
75

Competitive Equilibrium with LST

prices are p=1 for coconuts and wh and wl for the two types
of labour
CRS

firms make zero profits

Consider a LST that depends on ability:

ah = wh and al = wl
(Th , Tl )

Ti is the lump sum tax (which is a transfer received if

negative)
Budget constraint for individual with ability i is

c i = a i (H z i ) T i

 To achieve equal consumption, we must have

a h (H z h ) T h = a l (H z l ) T l
Since a h > a l and we want z h < z l we must have

Th > 0, Tl < 0
High ability workers should work more and be taxed, low
ability workers should work less and receive a benefit.

 If ability is unobservable, base tax on observed income

First best requires

q
that higher
g
income individuals ppay
y T and
lower income individuals receive T, such that consumption
equalises
high ability lose incentive to work, instead earn low income to mimic
low ability individuals

78

Implications
Impossible
p
to differentiate lump-sum
p
taxes by
y unobservable
characteristics!
Taxes must be based on observed behaviour (or characteristics)
When characteristics are private information, redistribution must
involve taxes that are distortionary.
1. Some conditions for first best Pareto Efficiency will not hold
2. Theory of the second best suggests Pareto Efficiency in
remaining markets may not be first best neither

Policy prescriptions cannot be based on Second Welfare

Theorem: cannot separate out efficiency from equity
79

Summary
Second Welfare Theorem: any Pareto efficient point is achievable
by LST and competitive markets
allows us to separate out efficiency from equity

2nd Best: if distortion in one market, it may be optimal to introduce

an extra distortion elsewhere to offset the first one (rather than
trying to satisfy Pareto conditions)
Unable to use lump sum taxes because of private information about
endowments
d
((off ability).
bili ) Should
Sh ld not try to maintain
i i separation
i
between equity and efficiency

80