1. Welfare Economics and the Environment (Ch. 5)

2. Introduction Welfare Economics:
Provides framework for analysing many policy questions related to the environment
Structure:
Conditions for efficiency and optimality
Partial equilibrium analysis
General equilibrium analysis
Market failures related to environment
Welfare Economics

3. 1. Conditions for efficiency and optimality
Definitions
Economic efficiency
An allocation of resources is efficient if it is not possible to make one or more persons better off without making at least one other person worse off (= Pareto optimality/efficiency, allocative efficiency)
Optimality
An allocation of resources is optimal if it maximizes the social welfare that can be obtained from these resources
Welfare Economics

4. 1. Conditions for efficiency and optimality
Definitions
Marginal rate of utility substitution (MRUS)
The rate at which one commodity can be substituted at the margin for another without changing a person’s utility
NB: equals the slope of the indifference curve
Marginal rate of technical substitution (MRTS)
The rate at which one production factor can be substituted at the margin for another without changing the output of the commodity
NB: equals the slope of the isoquant
Welfare Economics

5. 1. Conditions for efficiency and optimality
Definitions
Marginal rate of transformation (MRT) of a production factor
The rate at which the output of one commodity can be transformed into output of another commodity by a marginal shift of a production factor from one production process to another
NB: Equals the slope of the production possibility frontier
Welfare Economics

6. 1. Conditions for efficiency and optimality
Economic efficiency:
Efficiency in consumption
Efficiency in production
Efficiency in product mix
Welfare Economics

7. Figure 5.1 Efficiency in consumption. BY
AXb S
AXa A0 AX
IB1
IB0 IA a
BYa .
AYa
BYb . b
AYb
IB1
IB0 IA BX B0
BXa
BXb T
Welfare Economics AY

8. 1. Conditions for efficiency and optimality
Consumption efficiency requires that the MRUS is equal for all individuals
Welfare Economics

9. Figure 5.2 Efficiency in production. KY
LXa
LXb X0 LX
IY1
IY0 IX
KYa . a
KXa
KYb . b
KXb
IY1
IY0 IX LY Y0
LYa
LYb
Welfare Economics KX

10. 1. Conditions for efficiency and optimality
Production efficiency requires that the MRTS is equal for all commodities
Welfare Economics

11. Figure 5.3 Product-mix efficiency. YYM a Ya b Yb Yc c I XM X Xa Xb XC
Welfare Economics

12. 1. Conditions for efficiency and optimality
Product-mix efficiency requires that the MRT of all production factors are equal to the MRUS
NB: For an economy with given quantities of resources, production functions and utility functions, there are many efficient allocations of resources
Welfare Economics

13. Figure 5.4 The set of allocations for consumption efficiency.BY S A0 AX B A C B A B A B A B B A A . B A B A B A C A B BX B0 T
Welfare Economics AY

14. Figure 5.6 Maximised social welfare.UB W a b c W UA
Welfare Economics

15. 1. Conditions for efficiency and optimality
Optimality requires that the slope of the social welfare function (social indifference curve) equals the slope of the utility possibility curve
Hence:
efficiency is a necessary but not sufficient condition for optimality
an efficient allocation of resources may have lower social welfare than an inefficient allocation
Welfare Economics

16. Figure 5.7 Welfare and efficiency.UB D E C W2 W1 UA
Welfare Economics

17. 1. Conditions for efficiency and optimality
Basic Assumptions
Institutions
Markets exists for all goods and services
All markets are perfectly competitive
All agents have perfect information
Private property rights are assigned to all goods and services
There are no externalities
All goods and services are private goods (not public goods)
All utility and production functions have standard properties
Welfare Economics

18. 1. Conditions for efficiency and optimality
Basic Assumptions
Behaviour
Producers are profit maximisers
Consumers are utility maximisers
Assumptions are very strict & not realistic
Serve as a benchmark in welfare analysis of actual economies and for designing appropriate policies
Welfare Economics

19. 1. Conditions for efficiency and optimality
Approaches:
Partial equilibrium analysis (for 1 good/sector)
General equilibrium analysis (all economic sectors)
Welfare Economics

20. PARTIAL EQUILIBRIUM: Figure 5
PARTIAL EQUILIBRIUM: Figure 5.11 Partial equilibrium interpretation of economic efficiency.
B(X)
C(X) d
B(X*)
NB(X*)
C(X*) e a X X*
(a)
NB(X)
NB(X*)
NBX X* X
(b) g
MCX f
MBX h
(c) X* X g/
SX=MCX f/ Px h/
DX=MBX
(d) X* X

21. 1A. Partial equilibrium analysis
MB-curve:
Demand curve
Expresses ‘willingness to pay for a commodity’
MC-curve:
Supply curve
Shows marginal costs involved in producing an additional unit
Welfare Economics

22. 1A. Partial equilibrium analysis
Consumer surplus (CS):
Triangle g’f’px
Shows gains of consumers (who pay a lower price than they are willing to pay)
Producer surplus (PS):
Triangle h’f’px
Shows gains of producers (who receive a higher price than the price for which they are willing to sell)
CS+PS = maximised net benefit (=total welfare gain of trading a good in the market)
Welfare Economics

23. 1A. Partial equilibrium analysis
Advantages and disadvantages:
Examines efficiency in consumption and production, but not production-mix efficiency
Requires less data and research time than general equilibrium approach
Welfare Economics

24. 1B. General equilibrium analysis
Can be used to show that if the basic assumptions for institutions and behaviour (see above) are satisfied:
A market allocation of resources is an efficient allocation
Welfare Economics

25. Figure 5.8 Utility maximisation. Yb Y* U* c X X*
Xmax
Welfare Economics

26. 1B. General equilibrium analysis
Consumption efficiency:
Because all individuals face the same prices, the MRUS is the same for all individuals
Welfare Economics

27. Figure 5.9 Cost minimisation. Y K3 X* K2b c X* L L1 L2 L3
Welfare Economics

28. 1B. General equilibrium analysis
Production efficiency:
Because all producers face the same production factor prices, the MRTS is the same for all producers
Welfare Economics

29. 1B. General equilibrium analysis
Product-mix efficiency:
MRUS is equal to the price ratio of products (Fig. 5.8)
Because all producers are profit maximisers, the MRT for a production factor is equal to the price ratio of products (see p. 118)
Hence: MRUS = MRT for all production factors (5.11)
Welfare Economics

30. 2. Market failures related to environment
Major result of Part 1:
A market allocation of resources is an efficient allocation, if the basic assumptions for institutions and behaviour are satisfied.
Market failures: Situations where actual circumstances deviate from the ideal.
Analysis of market failures —> policy recommendations to improve economic efficiency
Welfare Economics

31. 2. Market failures related to environment
Basic assumptions on institutions:
Markets exists for all goods and services
All markets are perfectly competitive
All goods and services are private goods (not public goods)
There are no externalities
All agents have perfect information
Private property rights are assigned to all goods and services
All utility and production functions have standard properties
Welfare Economics

32. 2A. Market failures: Public goods
Private goods:
Rivalry: Consumption/use by one person/producer reduces amount available for consumption/use by others
Excludability: It is possible to exclude specific persons/ producers from consuming/using the commodity
Examples: bread, ice cream, coca cola, cars, car parts
Public goods:
Exhibit neither rivalry nor excludability
Examples: lighthouses, national defence force, clean air
Welfare Economics

33. 2A. Market failures: Public goods
Open access resources:
Exhibit rivalry but not excludability
Examples: ocean fish, groundwater, migratory birds
Toll goods/congestible resources:
Exhibit excludability but not rivalry
Examples: wilderness area, city park, cinema, toll roads
Welfare Economics

34. 2A. Market failures: Public goods
Markets cannot supply public goods due to the non-excludability.
Public goods have to be supplied by an entity that can recover production costs from other sources than market sales: Government taxes
Welfare Economics

35. 2A. Market failures: Public goods
Efficient level of public goods provision:
Level where aggregate marginal willingness to pay equals marginal costs of provision
Problems:
information is difficult to acquire
individuals have incentives to provide incorrect information
way of taxing has important equity implications
Welfare Economics

36. 2B. Market failures: Externalities
Externalities / external effects:
Consumption or production by one person/producer has unintended impact on utility or profit of other person(s)/producer(s)
No compensation/payment is made by the generator to the affected person(s)/producer(s)
Can be positive or negative
Examples:
Radio noise, vaccination, water pollution, bee hives
Welfare Economics

37. 2B. Market failures: Externalities
Consequences:
Due to absence of compensation/payment, the producer/consumer will not take the externality into account in decision making. Private costs (or benefits) therefore deviate from social costs (benefits), and the market will produce either too much (negative externality) or too little (positive externality) of the good.
Welfare Economics

38. 2B. Market failures: Externalities
Two cases:
Externality is private or toll good (e.g. noise pollution, water pollution)
Externality is public good (e.g. air pollution)
Welfare Economics

39. 1. Externality is private or toll good
Figure The bargaining solution to an externality. MB
MEC a c b d
Hours of music M* M0
Welfare Economics

40. 2B. Market failures: Externalities
Affected person/producer does not have a property right in an unpolluted environment. Hence, no compensation is paid and pollution will continue until the marginal benefit is zero.
Solution: Establish private property right in non-polluted environment (for affected person/producer)
This will cause a bargaining process until MB=MEC, and reduce environmental pollution to M*
NB: Pollution is not zero in M*; this level, however, is the efficient level of pollution.
Welfare Economics

41. 2B. Market failures: Externalities
Alternative solution: Establish private property right in environmental pollution (for pollution generator)
Consequences:
Causes similar bargaining process until MB=MEC
Now the pollution victim(s) should pay the generator
Hence:
Both solutions lead to the same efficient outcome
Welfare/equity implications are different
= Coase theorem
Welfare Economics

42. 2B. Market failures: Externalities
Assignment of property rights is not often used to correct externalities:
Legislators also have non-economic objectives
Bargaining is costly (espec. with many generators & victims)
Many externalities have public good characteristics
Welfare Economics

43. 2B. Market failures: Externalities
2. Externality is public good (‘public bad’)
Assignment of property rights and private bargaining will not deal with the problem; public intervention is required, e.g. taxation of pollution generator
Optimal tax level:
Makes output price equal to social marginal costs SMC (= private marginal costs PMC + marginal environmental costs MEC)
Welfare Economics

44. Figure 5.14 Taxation for externality correction.
SMC
PMCT
PMC PY t Y Y* Y0
Welfare Economics

45. 2B. Market failures: Externalities
Taxing agency will have to identify the optimal production level Y* , and then calculate the tax rate t*. To do so, it will need information on the willingness to pay of the affected persons at different production/pollution levels.
Problems (see above):
information is difficult to acquire
individuals have incentives to provide incorrect information
way of taxing has important equity implications
Welfare Economics

46. 2C. Market failures: Imperfect information
Condition for efficiency: All agents have perfect information.
Reality:
Some agents (victims, generators) may be unaware (e.g. smoking); result; no bargaining process; solution: information provision (= public good) by government
No accurate or unambiguous information (e.g. global warming); implications: see Ch. 8
Welfare Economics