Unit 2 Seminar PP 640

Bergson-Samuelson Individualistic Social Welfare Function Ranks social outcomes in terms of how individuals view personal well-being at each possible outcome Each outcome provides individuals with different levels of utility → Some individuals will receive more; some will receive less The social welfare function ranks outcomes by the effect such changes have on overall welfare received by a society Defines a set of ethical rankings that define a set of social indifference curves

Social Welfare Indifference Curves The ethical ranking defines a set of social welfare indifference curves that are analogous to individual indifference curves (except trade-off is between different individuals’ utility levels rather than different goods) Society is indifferent between A and B because they provide the same level of social utility Society prefers C to either A or B because it provides more social utility Society’s willingness to trade one person’s utility for another’s is called the social marginal rate of substitution

The Pareto Principle One of few things about which all economists agree regarding the issue of distributive justice If any one person’s utility increases (decreases), with everyone else’s utility held constant, then social welfare should also increase (decrease) The social welfare function is not a market-based concept → Must be determined collectively through political process

The Bliss Point The bliss point is a quantity of consumption such that further increases would make the consumer less satisfied. – It is a quantity of consumption which maximizes utility in the absence of any budget constraint. – It refers to the amount of consumption that would be chosen by a person so rich that money imposed no constraint on his or her decisions.

Marginal utilities of income Marginal utilities of income are determined by individuals based on preferences they have for stuff they buy with extra income Individual utility levels depend in large part on the amount of income individuals have (i.e. need income to buy stuff)

Marginal Social Welfare Weights The marginal social welfare weights are determined collectively by society through some political process The optimal condition: – To reach the social bliss point the social marginal utilities must be equal for all individuals

Taxing and redistribution If social marginal utilities are not equal for all individuals then: →Wealth needs to be redistributed so that person 1 gains utility and person 2 loses utility - Accomplished by taxing 2 and redistributing to 1 →This increases social welfare continues until doing so no longer increases social welfare,

Policy implications Lump-Sum Taxes and Transfers What kind of tax is appropriate for the redistribution described above? The tax must be non-distorting (must not introduce inefficiencies by altering relative prices) – The only tax that is non-distorting is a lump-sum tax, which is a tax for which the amount paid cannot be altered by any economic decision made in response to the tax (cannot be an income or unit tax)

Summary: The Mainstream Theory of Distributive Justice Two great questions of end-results equity – What is the optimal distribution of individual well-being? If society is not at the optimal distribution, how should it redistribute to reach the optimum? Mainstream theory provides simple answers If society can establish an ethical ranking that can be represented by a Bergson-Samuelson social welfare function The optimal distribution of well-being occurs when social marginal utilities of income are equal across individuals If initial distribution is not optimal, government should lump-sum tax and transfer until bliss point is reached

Summary: The Mainstream Theory of Distributive Justice continued… Determining the Allocation of Resources Besides answering the distribution question, the social welfare function also determines the final allocation of resources among all possible efficient allocations – →The social welfare function is one of the linchpins of mainstream public sector economics theory

Problems in Applying the Mainstream Theory of Distributive Justice There are, however, a number of problems in applying the mainstream theory of distributive justice, and the remaining slides will explore these

Lump sum taxes and transfers In practice, taxes actually employed are not likely to be lump-sum → Optimal lump-sum tax must in some way be related to income or consumption, but such taxes are normally not lump-sum Example: Income tax Not truly lump-sum because relevant wage to firm is wage inclusive of tax, which creates distortion by increasing cost of workers

Unanswered questions A major problem with the social welfare function construct is that economics cannot answer several important questions, namely: – What is the social welfare function? – What should the social welfare function be? – Can there be a social welfare function?

What Is the Social Welfare Function? To satisfactorily utilize the social welfare function, an economist would need to know the marginal social welfare weights – The problem is that these values are determined by society through the political process and the political process is very difficult to judge – Hence, it is very difficult to know what a nation’s social welfare function is

What Should the Social Welfare Function Be? This question has been pondered for years without a convincing case made for one specific answer Instead, economists rely on two possible explanations: – Utilitarian Social Welfare – Rawlsian Social Welfare

Utilitarian Social Welfare Attributed to Jeremy Bentham ( ), a political economist in the late 18th and early 19th centuries Argues that the goal of government should be to maximize aggregate social welfare (the sum of individual welfares) The idea of maximizing this social welfare function is referred to as utilitarianism

Rawlsian Social Welfare Named after John Rawls ( ), a Harvard philosopher in the mid- to late- 20th century Argued that social welfare should be highly egalitarian Proposed that society should make decisions through a “veil of ignorance” - The idea is that in making decisions we are all handicapped by knowing our position in life - Those who know they are rich would never favor redistribution policies while those who know they are poor would always do so

Rawlsian Social Welfare continued Given that the rich never favor redistribution and the poor always do, simply asking people to vote for a policy is unlikely to reach the socially desirable outcome To overcome this inherent bias in our thinking it is necessary for each individual to act as if they did not know their true position in the income distribution and how that might affect their future outcomes (i.e. they would operate under a “veil of ignorance”) – →Then the rich might vote for redistribution if they thought there was a chance they might end up poor while poor might vote against it if they thought there was a chance they might end up rich

Rawlsian Social Welfare continued Rawls argues that under such a construct each individual’s goal would be to guarantee the maximum protection against the worst-case (minimum) possible outcome → The maximin policy – Social welfare equals the utility achieved by the member of society who is worst off – This social welfare function assumes that individuals are extremely risk averse and vote to guard against the worst possible outcome at the expense of all other possibilities

Rawlsian Social Welfare continued Economists tend to be unconvinced by the Rawlsian social welfare function for several reasons: – It is doubtful that individuals are so extremely risk averse – The Rawlsian principle violates the Pareto principle (i.e. all groups should count not just the worst-off)

Can There Be A Social Welfare Function? Kenneth Arrow (1921-) American economist in the 20th century and 1972 nobel laureate Arrow’s General Impossibility Theorem Addresses the question whether a democratic society can be expected to develop a consistent set of ethical rankings to solve the problem of distributive justice - Demonstrated that in general the answer to the above question is “no”

Arrow’s General Impossibility Theorem Assumed that most individuals agreed with 5 general principles 1. The social decision process must provide a complete ordering of social outcomes 2. Any individual preferences over social outcomes must be allowed 3. Social decision must honor the Pareto principle 4. The independence of irrelevant alternatives 5. Non-dictatorship → The key point of the impossibility theorem is that in general these 5 principles cannot all hold simultaneously

Arrow’s General Impossibility Theorem continued… Inconsistent preferences lead to indifference curves that cross, which cannot be the case Saying that social decisions in general might not be consistent with all 5 principles does not mean that they must be inconsistent A necessary consequence of such inconsistency is that any policy can win depending on order in which vote is taken This means that controlling the voting agenda is crucial when preferences are inconsistent (which usually occurs when policies are controversial)

The Atkinson Assumptions Sir Anthony Atkinson, a British economist in the late 20th century, pioneered the flexible form approach to defining the social welfare function to link the effect of income inequality to social welfare To do so, he had to make a series of assumptions – → Starts with assumption that each household’s utility is a function only of its income

The Three Main Assumptions 1. Equal marginal social welfare weights - must be equal for individuals with the same income (i.e. ethical rankings only consider individual’s economic circumstances) 2. Everyone has the same tastes or preferences - Every individual has the same utility function - Any differences in utility attained by two individuals result entirely from differences in income 3. Diminishing marginal utility of income Often justified by the fact that individuals choose to purchase insurance Suppose outcome is based on coin-flip; heads you are paid $50,000, tails you pay $50,000 – People choose to insure because they care more about lost income than potential gained income

The Three Main Assumptions continued (Diminishing marginal utility of income continued) Inherent in this assumption is the idea that a dollar taken from a richer person and given to a poorer person adds more utility to the poorer person than it subtracts from the richer person – → This suggests the need for interpersonal utility comparisons, which is a major problem for many economists

Implications of Atkinson’s Assumptions If redistribution is costless then government should tax all people with incomes above mean and give it to people with incomes below mean until all people have the mean income – This is clearly an unattractive outcome, but it does form a good (and simple) baseline from which we can begin thinking about more realistic policies – Intuition is that if society is to reject such total equity in favor of inequality there must be a good argument for doing so

Okun’s Leaky Bucket Mainstream economists argue that inequality is justified because lump sum taxes and transfers are not feasible and that redistribution plans are distorted and inefficient Example: Suppose government taxes everyone above mean income and redistributes it to everyone below → Economy would collapse because there would be no incentive to work In more realistic cases, redistribution policies entail efficiency losses that must be balanced against any gains from making income distribution more even

Okun’s Leaky Bucket continued Arthur Okun was a Yale economist (discovered a relationship between changes in unemployment and changes in GNP) wrote on redistribution programs: “The money must be carried from the rich to the poor in a leaky bucket. Some of it will simply disappear in transit, so the poor will not receive all the money that is taken from the rich.” The “leaks” in the bucket represent the efficiency costs of taxing and transferring, which are composed of three types …

Types of Efficiency Cost Deadweight Loss - If taxes and transfers distort so that consumers and producers face different prices, the economy is forced inside its UPF (because MRS ≠ MRT) and utility is lost that cannot be recovered Administrative Costs - Costs to government of administering the tax and transfer programs → Generally low for taxes but can be very costly for in-kind transfers such as Medicaid, which require hiring many employees to deliver and monitor quality of services Compliance Costs - Costs to taxpayers and transfer recipients of complying with the programs (i.e. time, money, and effort devoted to making sure they comply with the law) → Can be very costly

Efficiency Costs continued Consider two people, one rich (R) one poor (P) If society takes income from R and gives it to P, social welfare decreases to the extent that R loses utility and increases to the extent that P gains utility Under a distorting tax, an inequality is justified by efficiency costs of taxing and transferring (i.e. the leaky bucket) This means that economies might have to compromise between efficiency and equity

Redistribution as a Negative-Sum Game In previous examples, total social welfare decreased because the lost utility to the taxed parties exceeded the gained utility to the transfer recipients This does not necessarily have to be the case – → Suppose a transfer is used to educate the recipient thereby increasing their human capital leading to economic growth – →This could increase social welfare by enabling society to identify and invest in the most talented individuals regardless of their income status

Applications of the Atkinson Social Welfare Function Does the United States Care Much About Inequality? Short answer: No Arnold Harberger used Atkinson’s framework to demonstrate that, based on existing U.S. data, the country did not care much about inequality → Estimated that the leaky bucket took almost $0.67 of each $ taken from rich and intended for poor →Given that inefficiencies are likely less than 67% this could mean that inequality is not that important to US society

Social Mobility and Social Welfare Social mobility is the ability of individuals to move through distribution of income over time This is more an issue of process-equity than end-results equity. The degree of social mobility can greatly affect the ability of a government to redistribute wealth. Redistribution programs are designed to move people higher in the wealth distribution by giving them income. Social mobility moves people up in wealth distribution by their earning higher incomes

Social Mobility and Social Welfare continued What happens if a redistribution program gives income to a person who is upwardly mobile in the distribution? – - This individual may no longer require the income redistribution to move higher in the distribution because they will have already moved up on their own - The initial redistribution program will need to be altered to make sure that the individual no longer receives the redistribution – → If upward mobility is easier in a society it is more likely that redistribution programs will require continuous refining to reach the desired outcome – → In this sense the society may prefer less mobility because it will make optimal redistribution easier to conduct

Unit 2 Assignment Read the Unit 2 Scenario For this exercise, the ten survivors will act as a government based on the U.S. model. They must decide which of the three survivors will remain in the bunker by doing an analysis of the interaction of political and economic forces on their group. Create a 2-3 page memo that outlines the following:

Unit 2 Assignment – 1. Identify what methods might be utilized to determine who remains in the bunker – 2. Identify and describe what political and economic forces might have an impact on this decision – 3. Describe the impact each of these forces may have on their new community Utilize any combination of narrative, formulas, and charts to convey your response in the memo.

Unit 2 Assignments Read chapters 4 and 5 Participate in Discussions Submit your Unit 2 assignment by Tuesday midnight Please contact me with any questions!