Presentation outline (12/31/2010) Welfare economics Pigouvian Theory – dual criteria, criticism Pareto-optimality – conditions, criticism Other criteria Externalities – positive & negative Diagrammatic explanation of externality – pigovian tax Public goods, types of goods and free ride problem

Welfare economics  Welfare economics is a branch of economics that uses microeconomic techniques to determine the allocation efficiency within an economy and the income distribution associated with it. Therefore, it is a methodological approach to assess resource allocations and establish criteria for government intervention.

Pigouvian Theory (Microeconomics, theory and applications by Ghai and Gupta) A.C Pigou in his book ‘Economics of welfare’ distinguished social welfare and economic welfare. According to him, economic welfare is that part of social welfare that can be brought directly or indirectly into relation with the measuring rod of money. He defined economic welfare of the individuals as the amount of satisfaction or utility he enjoys at a particular time and social welfare as aggregate of welfare of all the individuals in the society. In order to explain his dual criterion for determining the social welfare he assumed that it is possible to compare the utility derived by consumers from goods and services. He also assumed that consumers aims at maximizing utility.

Pigou’s dual criteria for determining the social welfare: First criteria: Given the supply of factors of production social welfare increases with the increase in national income. National income is the sum of the market value of final goods and services produced by normal residents of the country in an accounting year. Thus increasing national income results in more satisfaction from more goods which increase in social welfare. Second criteria: Social welfare increases when transfer of real income from the rich to poor increases (but the transfer does not lead to decrease in national income).

Criticism: Pigou defines social welfare as the aggregate of utilities derived by the individuals in the society. As the concept of utility is subjective, it cannot be added and thus definition of social welfare is unrealistic. As the value of money keeps on changing, using money as a tool to measure economic welfare may be inaccurate.

Pareto optimality criteria The concept of Pareto- optimal or Paret – efficient is based on the criterion given by Italian economist Vilfredo Pareto. According to him, a situation is defined as Pareto-optimal (or efficeint) if it is impossible to make anyone better-off without making someone worse-off. The Pareto’s optimality criterion states that any changes that makes one member of the society better-off without making someone worse-off is an improvement in social welfare. Conversely, if any changes makes at least one member of the society worse-off without making any member better-off, then it is decrease in social welfare. In order to attain Pareto-efficeint situation, the following three conditions need to be satisfied:

Three conditions Condition 1: Efficieny in production: it means the efficient allocation of factors of production among the firms Condition 2: Efficiency in exchange of consumption it means the efficient distribution of commodities among the consumers. Condition 3: Efficieny in product mix or composition of output it means the efficient allocation of factors among commodities.

Criticism The criteria considered only those changes that make anyone better off without making someone worse-off. It does not take into account those changes that make few people better-off by making few people worse off. 1. As each point on the curve is Paret-efficent, there are infinite number of points which are Pareto-optimal. These various points are not comparable unless interpersonal comparison and value judgements are made. 2. Pareto-optimality is necessary but not sufficient conditions for the welfare maximization. In other words, a situation may be Pareto-optimal without maximising social welfare. Thus this criterion does not ensure the maximization of social welfare.

Other criteria's Kaldor – Hicks Compensation criterion Scitovsky’s double criteion Bergson’s Criterion

Externalities The buyer and seller of a packaged good do not consider that the packaging material must be disposed in some way. The costs of a garbage collection and disposal scheme, if one exists, are not reflected in the price of the packaged good and someone else- the local or national tax payer pays that cost. If no organized collection and disposed scheme exists, the garbage is simply disposed in environment as litter in roadside waste or in unregulated landfill tips as waste. In many developing countries for example, considerable amount of waste are fly-tipped (disposed off anywhere) legally or illegally in rivers, or land, or in open bonfires.

Such unregulated or unsystematic disposal of waste generate risks that entails a third party cost that is not reflected in the price of the packaged good. In economic terms, those costs are an external effect. External benefit are possible but tend to be less common than external costs. External effects or externalities are market failures, that is, they are a distortion arising because markets fail to function effectively. The distinction between market failure and policy failure is ambiguous. After all, governments can alter market prices to reflect, albeit approximately, the external costs of production and consumption. To that extent their failure to do so is a policy failure, they fail to maximize social welfare.

Nonetheless, social cost pricing is not necessarily a distant or unpractical prospect. Government often have the means to effect approximate adjustments for external costs: they can, for example, raise gasoline taxes to account for the air pollution, congestion, and noise caused by the vehicles. Environment economics analyze pollution as an externality. An externality is any impact on a third party’s welfare that is brought about by the action of an individual and is neither compensated nor appropriated.

Types of externality Thus, in economics, an externality is a cost or benefit, not transmitted through prices, incurred by a party who did not agree to the action causing the cost or benefit. A benefit in this case is called a positive externality or external benefit, while a cost is called a negative externality or external cost.

Examples Negative externalities Anthropogenic climate change Water pollution Alcoholic driving Positive externalities Beekeeping Individual planting Education and health

Supply and demand with negative externality

Supply and demand with positive externality

Public goods Public good is a good that is non- rivalrous and non-excludable. Non-rivalry means that consumption of the good by one individual does not reduce availability of the good for consumption by others; and non-excludability that no one can be effectively excluded from using the good.

Non-rivalness and non-excludability may cause problems for the production of public goods. Some economists argue that the nature of public good lead to instances of market failure, where uncoordinated markets driven by parties working in their own self interest are unable to provide these goods in desired quantities.

Type of goods and their properties Exclusive: Private land based goods: -Commodity production -Mineral extraction Non-exclusive Common property goods: -Lake, river system Public forest Public park Club goods: Resorts Golf courses Heli-skiing, sky-diving Purely public goods: -Aesthetics -Sun-sets -Defense of land base Level of Exclusivity Level of Rivalry Rival Non rival

Free rider problem Public goods provide a very important example of market failure in which market-like behavior of individual gain-seeking does not produce efficient results. The production of public goods results in positive externalities which are not remunerated. If private organizations don't reap all the benefits of a public good which they have produced, their incentives to produce it voluntarily might be insufficient. Consumers can take advantage of public goods without contributing sufficiently to their creation. This is called the free rider problem.

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