CONCEPTUAL FOUNDATIONS OF CBA LECTURE 3 ECON 445 CONCEPTUAL FOUNDATIONS OF CBA LECTURE 3 E. Nketiah-Amponsah Department of Economics Room W.18 enamponsah@ug.edu.gh

Introduction Pareto Efficiency is the foundation of modern welfare economics and CBA. CBA provides a framework for analyzing the efficient utilization of society’s scarce resources Even when other goals than efficiency are important, CBA serves as a basis for evaluating the relative efficiency of alternative policies.

Meaning and Scope of Pareto Efficiency The concept of Pareto Optimality also called Pareto Efficiency was developed by an Italian economist-Vilfredo Pareto (1848-1923) Vilfredo applied the concept(Pareto efficiency) to study economic efficiency and income distribution. It has since been used extensively by economists and other social scientist to analyze efficient use of society's scarce resources. Pareto Efficiency: What is it? An allocation of goods is pareto efficient (also pareto optimum) if no alternative arrangement can be found such that at least one person is made better off without making anyone-else worse off. In the context of the economy, a pareto-efficient allocation of resources among users exists if it is not possible to reallocate resources so as to improve the well-being or utility of one person without making at least one person worse-off (i.e reduce their utility)

Meaning and Scope of Pareto Efficiency-Cont A change in the economy is said to represent a pareto improvement (pareto superior) if at least one person is made better off as a result of the change or policy and no person is made worse off. An allocation of goods is thus inefficient if an alternative allocation/arrangement can be found that would make at least one person better off without making anyone else worse off (pareto improvement, pareto superior etc) The pareto criterion is similar to a voting rule that requires unanimity. The appeal of the pareto notion of efficiency is that it seems to eliminate interpersonal comparison of welfare.

Edgeworth Box Individual B Total amount of YB Individual A XA

Pareto Inefficient Allocation a and b are Pareto inefficient allocations. Why? Because there exists changes in allocations, starting from a or b, that would make at least one individual better off without making the other individual worse off (without reducing the welfare of the other individual).

Edgeworth Box g Individual B Total amount of g is a pareto efficient point g Individual A Total amount of

Meaning and Scope of Pareto Efficiency-Cont A pareto optimum is therefore a situation in which no pareto improvement is possible In the real world, Pareto Optimality is very stringent to achieve given that most changes in the economy cannot be judged by the pareto principle since such changes involve some persons being made better off and others worse off. In practice, all public policies result in gainers and losers

Marginal Conditions for Pareto Efficiency We know from Microeconomics that for an economy to achieve pareto efficiency, 3 marginal conditions must be satisfied/fulfilled The condition for efficiency in the allocation of factors among firms (production efficiency condition) Efficiency in the distribution of commodities among consumers (exchange efficiency condition) Efficiency in the allocation of factors among commodities (condition for efficiency in the composition of output) The 3 marginal efficiency conditions suggest that efficiency is not limited to any particular economic agent but encompasses the firm, household and the economy as a whole

Marginal Conditions for Pareto Efficiency MRS = MRPT = Px/Py UA Px/Py Px/Py UB x

Marginal Conditions for Pareto Efficiency In summary, three Conditions must be satisfied to pareto efficiency:

Net Benefits and Pareto Optimality There is a direct and a positive link between positive net social benefits and pareto efficiency If a policy has positive net benefits, then it is possible to find a set of transfers or a compensation package that makes at least one person better off without making anyone else worse off Positive net benefits indicate the potential to make the policy pareto efficient Negative net benefits indicate the absence of such potential

Some challenges/difficulties in applying Pareto Efficiency Though the concept is conceptually appealing, achieving pareto efficiency is practically difficult for number of reasons including but not limited to: Informational burden on the CBA Analyst Consider the case of measuring all the cost and benefits for a project of national character What about non-marketed impacts? Even if all the costs and benefits at the individual level were known, the administrative costs of effecting specific transfers for each government policy would be high

Some challenges/difficulties in applying Pareto Efficiency The requirement that everyone be fully compensated for the harm (costs) caused by the introduction of a project or policy would create a strong incentive for people to devise strategies to overstate costs and understate benefits. It is practically difficult to operate a system of compensation that does not distort the investment and work behaviour of households work leisure-trade off could be distorted by a given government policy/project Potential effect on investment

Potential Pareto Optimality:Kaldor-Hicks Efficiency Kaldor–Hicks efficiency: named after Nicholas Kaldor and John Hicks, also known as Kaldor–Hicks criterion, is a measure of economic efficiency that captures some of the intuitive appeal of Pareto efficiency, but has less stringent criteria and is hence applicable to more circumstances than the actual pareto efficiency rule. Under Kaldor–Hicks efficiency, an outcome is considered more efficient if a Pareto optimal outcome can be reached by arranging sufficient compensation from those that are made better off to those that are made worse off so that all would end up no worse off than before. Adopt only policies that have positive net benefits. It is at least possible that losers could be compensated so that the policy could be pareto improving. Consider the case for a tax policy ??? What about clearing part of a forest for the construction of a road?

Potential Pareto Optimality:Kaldor-Hicks Efficiency Using Kaldor–Hicks efficiency, an outcome is more efficient if those that are made better off could in theory compensate those that are made worse off, so that a Pareto improving outcome results. For example, a voluntary exchange that creates pollution would be a Kaldor–Hicks improvement if the buyers and sellers are still willing to carry out the transaction even if they have to fully compensate the victims of the pollution. Practically, the compensation principle often appealed to is hypothetical. That is, for the alleged Pareto improvement (say removal of tariffs) some losers are not (fully) compensated. The change thus results in distribution effects in addition to any Pareto improvement that might have taken place. The theory of hypothetical compensation is part of Kaldor-Hicks efficiency, also called Potential Pareto Criterion.

Justification for the Potential Efficiency Rule By choosing policies with positive net benefits, society maximizes aggregate wealth. This indirectly improves the welfare of those who are worse off in society granted that richer societies have greater capability for assisting their poorest members. Through spill-over/ripple effects from investments undertaken by the wealthier Assuming redistribution is a normal good, members of society have a greater willingness to help It is likely that different policies will have different sets of winners and losers If the rule is consistently applied to government projects and policies, then cost and benefits will tend to average out across society such that each person is likely to benefit from different policies (repetitive game) If a more egalitarian distribution of income is an important societal goal, then it is possible to address inequity directly through transfers after a large number of efficiency enhancing policies have been adapted.

Criticisms of Potential Pareto Optimality As a potential CBA analyst, carefully identify deficiencies associated with the Pareto Optimality concept. Is there any reasonable justification for embarking on projects with positive net benefits?.