PARETO OPTIMALITY AND THE EFFICIENCY GOAL

SOCIAL GOALS AND THE ROLE OF THE RATIONAL INDIVIDUAL CBA is based on neoclassical welfare economics CBA embodies (classic) “Liberal” philosophy with following components: 1. individual is fundamental unit of society Individual preferences count 2. rational decision-making by individuals 3. rational individual’s preferences can be meaningfully aggregated in some manner to make social decisions about resource allocation in society

THE INDIVIDUAL AND SOCIETY Society essentially composed of individuals motivated by self-interest Law and government provide security against equally self-interested fellows Government and society exist to preserve the individual’s rights Individuals acting in enlightened self-interest lead to the maximum common good Public interests are conceived in terms of private well-being

THE INDIVIDUAL AND ECONOMY Individuals gain satisfaction or utility fromo consumption These individuals have preferences The values or strengths of this utility is manifested in prices formed in the market place The more individuals value or demand or derive satisfaction/utility, the higher the price and their willingness to pay

THE INDIVIDUAL AND ECONOMY Thus, money valuations express individual preferences

THE INDIVIDUAL AND ECONOMY Collective Rationality and Aggregation of Money Valuations Basic question is how to aggregate individual money valuations to form collective or social valuations These social valuations are used to make social (collective) decision-making Basic approach is to simply sum the individual money valuations Summation gives net benefits to society

DISTRIBUTION OF INCOME AND WEALTH Judgements about the distribution of income and wealth are largely implicit in CBA Implicitly, the desired income distribution is the one prevailing at the time of CBA Because money valuations reflect willingness to pay But willingness to pay as reflected by market behavior is a function of ability to pay

VALUES WHEN MARKETS DO NOT EXIST Individuals’ preferences are measured as prices and willingness to pay Gives the level of economic welfare from consumption Prices and hence values are formed by market activity

VALUES WHEN MARKETS DO NOT EXIST Sometimes markets do not exist Biodiversity is one example No prices exist in a market that individuals are willing to pay However, prices and willingness to pay can, in principle, be imputed from observed behavior

SUMMARY TO THIS POINT Benefit-cost analysis is based on neoclassical welfare economics CBA and welfare economics embody the philosophy of individual consumer sovereignty Social economic welfare is assumed to be the sum of self-expressed welfares of all individuals in society Expressed through market prices and WTP

SUMMARY TO THIS POINT A benefit is considered a gain in welfare A cost is considered a loss in welfare Net benefits are an aggregation of all benefits minus an aggregation of all costs In making judgements about optimal resource allocations, decision criterion is required to evaluate alternative economic states

SUMMARY TO THIS POINT That is, alternative economic states, i.e. alternative allocations of scarce social resources, each have corresponding summed net benefits Some criterion is required to evaluate these alternative economic states In welfare economics, and thus CBA, this criterion is Pareto optimality A value judgement

THE CONCEPT OF PARETO OPTIMALITY Paretian System Concept of Pareto optimality underlies the value judgements used to choose among alternative resource allocations – alternative economic states – with the greatest net benefits

PARETO OPTIMALITY Paretian System Two fundamental components of Paretian value system 1. Individual preferences count 2. Prevailing income distribution is desireable

PARETO OPTIMALITY Pareto Criterion Purpose Pareto criterion is a technique for comparing or ranking alternative states of the economy Definition of Pareto Criterion If it is possible to make at least one person better off in moving from state A to state B without making anyone else worse off, state B is ranked higher by society than state B

PARETO OPTIMALITY Pareto Criterion Pareto Improvement A movement from state A to state B Pareto Criterion vs.Unanimity Pareto criterion allows indifference by some individuals (some not made worse off)

PARETO OPTIMALITY Pareto Optimum A state of the economy from which it is impossible to make one person better off without making another person worse off. If society finds itself in a position from which there is no Pareto improvement, then there is a Pareto optimum If economy is not in Pareto optimum, some inefficiency in the economy

PARETO OPTIMALITY Weak Pareto Criterion Strong Pareto Criterion Everyone is made better off. Strong Pareto Criterion Some people are made better off, while noone is made worse off. Pareto criterion breaks down if even one individual is made worse off.

PARETO OPTIMALITY Graphically Utility Person B Set of Pareto improvements Utility Possibility Curve Corresponds to all possible combinations of utility for individuals A and B for given production possiblity frontier Pareto-inefficient starting point Utility Person A

PARETO OPTIMALITY AND INCOME DISTRIBUTION Pareto optimality gives an efficient resource allocation and maximum social welfare for a given income distribution If change existing income distribution, then new Pareto optimum Hence, many Pareto optimum may exist associated with different factor endowments (incoome distributions)

PARETO OPTIMALITY AND INCOME DISTRIBUTION Implies cannot solve problem of efficiency and income distribution in two stages by: 1. First, Pareto-efficient resource allocation 2. Optimum distribution No solution by Pareto criterion

PARETO OPTIMALITY AND INCOME DISTRIBUTION Graphically Two different distributions of income give two different Pareto optimums, A and B All such combos of utility, for given income distribution, gives UPF How to choose A vs. B? Cannot by Paerto criterion Need social welfare function But Arrow’s Impossibility Theorem says cannot for democratic society Utility Individual A Contract curve A A Utility Possibility Frontier B Contract curve B Utility Individual B

LIMITATIONS TO PARETO CRITERION 1. Breaks down if single individual made worse off 2. Many alternatives simply not comparable Alternative Pareto optimum (corresponding to different income distributions) not Pareto comparable Pareto criterion does not allow choosing between alternative income distributions 3. Favors status quo 4. Not all first-best Pareto-optimal choices are superior to some second-best (Pareto-inefficient) choices Second-best may have superior income distribution

POTENTIAL PARETO CRITERION Potential Pareto criterion is a way out of the limitations of the (“pure”) Pareto criterion Is modification of Pareto criterion and forms the basis for comparing or ranking alternative states of the economy by CBA Sometimes called Kaldor-Hicks Compensation Test Relies on compensation principle

POTENTIAL PARETO CRITERION Definition of Potential Pareto Criterion State A is preferable to state B if it is potentially possible to for the gainers to compensate the losers and still remain better off Actual compensation is not required

POTENTIAL PARETO CRITERION Example Gainers in state A receive 100 units of benefit Losers in state A penalized 90 units (their cost) If gainers potentially compensate losers by 90 units, gainers receive net benefit of 10 units

POTENTIAL PARETO CRITERION In market economies, compensation is not typically direct Instead, various forms of transfer payments Purpose of potential compensation is to separate efficiency and equity components of a policy change under consideration

POTENTIAL PARETO CRITERION Utility A I to any point between S0 and S1 is Pareto improvement All points on UPF in range S0S1 is Pareto-superior to I Move from I to E is not Pareto improvement in itself E S0 Potential Pareto Criterion ranks a Pareto-optimal allocation, such as E, superior to any allocation not Pareto optimal, such as I Potential Pareto Criterion allows point Such as E to be reached by potential compensation S S1 I Utility Possibility Fronter Utility B