Welfare Economics

Efficiency Efficiency vs. vs.

EqualityEquality

Self-Interest and the Social Interest

•When you buy a pair of shoes or a textbook , or even just take a shower, you express your view about how scarce resources should be used.•You make choices that are in your self-interest.•Markets coordinate your choices with those of everyone else.•Do markets do a good job?•Do they enable our self-interest choices to be in the social interest?•And do markets produce a fair outcome?

Efficiency and the Social Interest

• Allocative efficiency is one aspect of the social interest and the aspect about which economists have most to say.

• An efficient allocation of resources occurs when we produce the goods and services that people value most highly.

• Resources are allocated efficiently when it is not possible to produce more of a good or service without giving up some other good or service that is valued more highly.

• Efficiency is based on value, and people’s preferences determine value.

Efficiency: A Review

Figure shows an efficient pizza market:

1. Market equilibrium.

2. Marginal cost curve.

3. Marginal benefit curve.

4. When marginal cost equals marginal benefit, quantity is efficient.

5. Consumer surplus plus

6. Producer surplus is maximized.

Efficiency of Competitive Equilibrium

At the market equilibrium, resources are used efficiently.

Equilibrium quantity is the quantity that people value most highly.

To produce more of one good, some of another good that is valued more highly must be given up.

To produce less of one good, more of another good that is not valued as highly as the one forgone will be produced.

In a competitive market:• The demand curve shows buyers’ marginal benefit. • The supply curve shows the sellers’ marginal cost.

So at the equilibrium in a competitive market, marginal benefit equals marginal cost.

Resources are used efficiently.

So the competitive market is efficient.

The Invisible Hand• Adam Smith’s “invisible hand” idea in the Wealth

of Nations implied that competitive markets send resources to their highest valued use in society.

• Consumers and producers pursue their own self-interest and interact in markets.

• Market transactions generate an efficient—highest valued—use of resources.

Is the Competitive Market Fair?

Symmetry principle:

-The requirement that people in similar situations be treated similarly.

Two broad and generally conflicting views of fairness are:

It’s not fair if the result isn’t fair It’s not fair if the rules aren’t fair.

Not Fair if the Result Isn’t Fair

Utilitarianism: A principle that states that we should strive to achieve

“the greatest happiness for the greatest number.”

To achieve this outcome, income must be transferred from the rich to the poor until no one is rich or poor.

Only if everyone’s share of the economic pie is the same as everyone else’s are resources being used in the most efficient way and bringing the greatest attainable total benefit.

The Big Tradeoff

A tradeoff between efficiency and fairness that recognizes the cost of making income transfers.

The tradeoff is between the size of the economic pie and the degree of equality with which it is shared.

The greater the amount of income redistribution through income taxes, the greater is the inefficiency —the smaller is the economic pie.

Make the Poorest as Well Off as Possible

Harvard philosopher, John Rawls, proposed a modified version of utilitarianism in A Theory of Justice (1971).

Taking all the costs of income transfers into account, the fair distribution of the economic pie is the one that makes the poorest person as well off as possible.

The “fair results” ideas require a change in the results after the game is over. Some say that this in itself is unfair.

Not Fair if the Rules Aren’t Fair

This idea translates into “equality of opportunity.”

Harvard philosopher, Robert Nozick, in Anarchy, State, and Utopia, (1974) argues that the rules must be fair and must respect two principles:

• The state must enforce laws that establish and protect private property.

• Private property may be transferred from one person to another only by voluntary exchange.

The Sources of Economic Inequality

An unfair distribution of Income and Wealth in the Economy.

1. Inequality in labor income- The more human capital (abilities, skills, etc.) a person

possesses, the more income that person likely earns, other things remaining the same.

2. Inequality in property income-It consists of income on assets like stocks, bonds, & realestate.The people at the very top of the income pyramid derive most of their money from property income.

Income Redistribution

The three main ways governments redistribute income are:

• Income taxes

• Income maintenance programs

• Subsidized services

Income Taxes

The central government and most state governments tax incomes.

By taxing incomes of different levels at different tax rates, economic inequality can be decreased.

A progressive income tax is one that taxes income at an average rate that increases with income.

Income Maintenance Programs

Three major types of programs provide direct payments to individuals:

Social security programs

Unemployment compensation

Welfare programs

Subsidized Services

A great deal of redistribution takes the form of subsidized services—services provided by the government at prices below the cost of production.

An example is primary and secondary public education, as well as state colleges and universities.

The students at these institutions generally pay tuition and fees that range from 20 to 25% of the actual cost of educating a college student.

The families of these students enjoy a sizeable subsidy for acquiring human capital.

Redistributing income leads to a tradeoff between equity and efficiency, known as the big tradeoff. Programs to redistribute income are inefficient for three reasons:

The process of income redistribution uses up resources that could have otherwise been used for producing goods and services.

Redistribution of income requires taxes to be imposed on the economy, which generates a deadweight loss in the markets that are taxed.

Income redistribution decreases the incentives for :

1. Taxpaying workers to provide labor when leisure is a normal good (by decreasing income from work) and

2. Income assistance recipient’s to provide labor and earn income.

“..the conflict between equality and economic efficiency is inescapable.”

-Arthur Okun (1975)

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