Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 1 of 43 Social Efficiency 2. 3  Social efficiency: When there is no ``free lunch’’. Someone has to pay.  Autarky, trade, and free lunch.  A PARETO-efficient state is where the is no more free lunch.  A Pareto-efficient state is when on cannot make someone better off without making somebody else worse off.  Having a free lunch is referred to as a Pareto improvement or making a Pareto improving move.  Pareto improvement: Making someone better off without making anybody else worse off (as in free trade).

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 2 of 43 Social Efficiency and Competitive Markets 2. 3  A competitive market tends to realize all free lunches.  A competitive market is Pareto efficient.  This is called: The First Fundamental Theorem of Welfare Economics.

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 3 of “Every individual necessarily labours to render the annual revenue of the society as great as he can. He generally indeed neither intends to promote the public interest, nor knows how much he is promoting it…. He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote as end which was no part of his intention.” Adam Smith, The Wealth of Nations, Book IV

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 4 of 43 Equilibrium and Social Welfare 2. 3 Equilibrium

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 5 of Social Efficiency Social efficiency represents the net gains to society from all trades that are made in a particular market, and it consists of two components: consumer and producer surplus. consumer surplus The benefit that consumers derive from consuming a good, above and beyond the price they paid for the good.

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 6 of Social Efficiency

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 7 of Producer Surplus producer surplus The benefit that producers derive from selling a good, above and beyond the cost of producing that good.

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 8 of Producer Surplus

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 9 of Social Surplus total social surplus (social efficiency) The sum of consumer surplus and producer surplus.

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 10 of Social Surplus

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 11 of Competitive Equilibrium Maximizes Social Efficiency First Fundamental Theorem of Welfare Economics The competitive equilibrium, where supply equals demand, maximizes social efficiency. deadweight loss The reduction in social efficiency from denying trades for which benefits exceed costs. It is sometimes confusing to know how to draw deadweight loss triangles. The key to doing so is to remember that deadweight loss triangles point to the social optimum, and grow outward from there.

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 12 of From Social Efficiency to Social Welfare: The Role of Equity social welfare The level of well-being in society. Governments have certain redistributiveprograms because their citizens care not onlyabout efficiency but also about equity, the fair distribution of resources in society. Thecompetitive equilibrium, while being the socialefficiency -maximizing point, may not be the social welfare -maximizing point.

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 13 of equity–efficiency trade-off The choice society must make between the total size of the economic pie and its distribution among individuals.

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 14 of From Social Efficiency to Social Welfare: The Role of Equity social welfare function (SWF) A function that combines the utility functions of all individuals into an overall social utility function.

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 15 of The Social Welfare Function: W=W(.)  The basis idea of the SWF is to make the society’s notion of “fairness” explicit.  Introduced by Samuelson and Bergson some fifty years ago.  Often people talk about being “fair” without specifying what they mean:  John Edwards often talks about “two Americas’’.  Is it only “two”? What does “one America’’ look like?  Bill Clinton, in his ’92 presidential campaign, talked about an “America in which the wealthiest, those making over 200,000 dollars a year, are asked to pay their fair share.”

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 16 of The Social Welfare Function: W=W(.)  But one can interpret this as :  Higher income people should pay more taxes. If we accept this interpretation we are still left with the question of “How much?”  Higher income people pay more in terms of average taxes. But again “How much?”  Higher income people pay more in terms of marginal taxes. But again “How much?”  William Safire, a previous columnist for New York Times, defines “tax fairness” as “the poor should pay nothing, the middlers something, and the rich the highest percentage.” So his is in terms of averages. But the question of how much still remains.

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 17 of Some Specific Examples Utilitarian SWF With a utilitarian social welfare function, society’s goal is to maximize the sum of individual utilities: SWF = U 1 + U U N The utilities of all individuals are given equal weight, and summed to get total social welfare.

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 18 of Linear Iso-Welfare Curves  Same MRS everywhere: perfect substitute  Jeremy Bentham: Utilitarianism U2U2 U1U1

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 19 of 43

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 20 of Rawlsian Social Welfare Function John Rawls suggested that society’s goal should be to maximize the well- being of its worst-off member. The Rawlsian SWF has the form: SW = min (U 1, U 2,..., U N ) Since social welfare is determined by the minimum utility in society, social welfare is maximized by maximizing the well-being of the worst-off person in society.  Deciding under the “veil of ignorance.”

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 21 of Perfect complements U2U2 U1U1 45° L-shaped Iso-Welfare Curves

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 22 of 43 John Rawls

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 23 of Atkinson social welfare function *ε is the Inequality Aversion Parameter. *We have -Asto a Utilitarian SWF -Asto a Rawlsian SWF

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 24 of 43 Anthony Atkinson

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 25 of ε2 > ε1ε2 > ε1 U2U2 U1U1 ε1ε1 ε2ε2

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 26 of 43  NOZIK: Equality of opportunity not outcomes: The principle that society should ensure that all individuals have equal opportunities for success, but not focus on the outcomes of choices made.  The island example  The measurement problem  Ex-ante versus Ex-post 2. 3

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 27 of 43 Robert Nozick

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 28 of Another idea Commodity Egalitarianism The principle that society should ensure that individuals meet a set of basic needs, but that beyond that point income distribution is irrelevant.

Chapter 2 Theoretical Tools of Public Finance © 2007 Worth Publishers Public Finance and Public Policy, Jonathan Gruber, 2e 29 of 43 Conclusion 2. 5 The notion of Pareto efficiency. The relationship between competitive markets and efficiency. Market failures. Efficiency gain and loss calculations. Equity and efficiency tradeoff. The notion of a social welfare function. Different types of SWF.