1. PARETO OPTIMALITY AND THE EFFICIENCY GOAL

2. 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

3. 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

4. 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

5. THE INDIVIDUAL AND ECONOMY
Thus, money valuations express individual preferences

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

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

15. 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

16. 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)

17. 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

18. 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.

19. 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

20. 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)

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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