Welfare Economics. Jan Abrell Centre for Energy Policy and Economics (CEPE) D-MTEC, ETH Zurich. Welfare Economics
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1 Welfare Economics Jan Abrell Centre for Energy Policy and Economics (CEPE) D-MTEC, ETH Zurich Welfare Economics
2 Outline So far Basic Model Economic Efficiency Optimality Market Economy Partial Equilibrium Analysis Summary Welfare Economics
3 Summary: Economy in the Environment (1) Basic life-support function Hardly substitutable (2) Amenity services Often no resource use but rivalry in consumption Partly substitutable by capital Welfare Economics
4 Summary: Economy in the Environment (3) Waste sink/pollution Stock and flow pollution Global and local pollution Substitution using recycling or mimicking waste sink services (4) Natural resources Stock and flow resources Stock resources can be renewable Substitution by technology change, i.e., more efficient resource Welfare Economics
5 Summary: Drivers of Environmental Impacts IPAT identity: Kaya s identity IPAT for CO 2 defining technology as the product of energy and carbon intensity Environmental Kuznet Curve: Reasons: Scale and composition effects, technological change, environmental regulation Weak empirical evidences for EKC for local but not for global pollutants Welfare Economics
6 Today: Basic Model of Welfare Economics How do we efficiently allocate commodities/resources in an economy? How do we optimally allocate commodities/resources in an economy? Are markets a good tool to implement these allocation? What happens if we relax the assumptions of the basic model? Public goods Externalities Welfare Economics
7 Outline So far Basic Model Economic Efficiency Optimality Market Economy Partial Equilibrium Analysis Summary Welfare Economics
8 What is An Economy? Consumers (denoted by i) Firms (denoted by f) Commodities (denoted by c) Natural environment Welfare Economics
9 What are commodities? Commodities, goods, resources: XX cc used to gain utility and produce other commodities (transformation) Main assumption: Commodity usage is private Commodity types: Standard goods Primary factors Natural resources Welfare Economics
10 Consumers Consumer i gains utility UU ii consuming commodity c: Main assumption No externalities: Utility only depends on own consumption Marginal utility is positive but decreasing Indifference curve Locus of all consumption bundles that provide the same utility level Welfare Economics
11 The Marginal Rate of Substitution (MRUS) Graphically MRUS is the slope of an indifference curve Intuitively MRUS tells how much of y is needed to compensate a change in x (holding utility constant) MRUS provides measure of substitutability of commodities Welfare Economics
12 Firms Use commodities and produce other commodities c (output): Production function expresses transformation technology Main assumption: No externalties: Output only depends on own inputs Marginal rate of technical substitution (MRTS) Amount of (e.g.) capital (K) needed to give up (e.g.) a unit of resources (R) holding output constant (= slope of isoquant) Welfare Economics
13 Allocation Allocation Describes how we distribute resources among consumers and firms Economics analyzes allocations and how we efficiently (or optimally) allocate resources among individuals Welfare Economics
14 Social Planer vs Market Economy Social planner Directly chooses allocation Market Economy Market and prices coordinate behavior of agents Social planner solution serves as reference case Welfare Economics
15 Outline So far Basic Model Economic Efficiency Optimality Market Economy Partial Equilibrium Analysis Summary Welfare Economics
16 Economic Efficiency An allocation is Pareto-efficient (or simply efficient) if it is not possible to make one individual better off without making an other individual worse off. Welfare Economics
17 Implications of Economic Efficiency An allocation is Pareto-inefficient (there exists an Pareto improvement) if we can make one individual better off without making another worse of No distributional statement Welfare Economics
18 Conditions for Pareto-efficiency Consumption efficiency Allocation of commodities among consumers Production efficiency Allocation of commodities among firms Product mix efficiency Allocation of produced and consumed commodities Welfare Economics
19 Efficiency in Consumption Marginal rate of substitution equalized across consumers Welfare Economics
20 Efficiency in Production Marginal rate of technical substitution equalized across firms Welfare Economics
21 Product-mix Efficiency Social indifference curve (I I) Set of all efficient consumption bundles Transformation curve (Y M X m ) Set of all efficiently produced outputs Marginal rate of transformation Slope of transformation curve Welfare Economics
22 Pareto-efficient Allocation is not Unique Contract curve Locus of all Pareto-efficient consumption allocations Utility possibility curve Locus of all Pareto-efficient utility combinations Which allocation to choose? Welfare Economics
23 Outline So far Basic Model Economic Efficiency Optimality Market Economy Partial Equilibrium Analysis Summary Welfare Economics
24 Optimality vs Efficiency Efficiency determines allocations in which resources are not wasted Optimality choose efficient allocation according to a welfare criterium Social welfare function (SWF) Provides ranking of utility combinations Welfare Economics
25 Social Welfare Functions are Distributional Statements a) Purely utilitarian SWF: b) Maxmin or Rawlsian SWF: c) Generalized utilitarian SWF: Welfare Economics
26 Welfare Optimality Condition Slope welfare function Slope utility-possibility curve Optimality implies efficiency Welfare Economics
27 Discussion Welfare functions are distributional statements Who decides? Dictator Voting (public choice) Often used approach Provide distribution impacts for different efficient allocations Sensitivity over slope of welfare function Welfare Economics
28 Outline So far Basic Model Economic Efficiency Optimality Market Economy Partial Equilibrium Analysis Summary Welfare Economics
29 Market Economy Market clearing (supply S satisfies demand D) determines prices p: Welfare Economics
30 Assumptions on Commodities (and Functions) Private commodities Commodity used by one agent cannot be used by another No Externalities Utility/output only depends on own resource consumption Already used to determine efficiency/optimality Additionally Regularity (technical) assumptions on utility and production functions Welfare Economics
31 Assumptions on Markets Property rights fully assigned Market can be established Markets exist for all commodities Prices for all commodities Perfect information for all agents No transaction costs Perfect competition on all markets Agents are price-takers Welfare Economics
32 Behavioral Assumptions: Consumers Given prices, consumers maximize utility given their budget (M) Slope budget line: p X /p Y Welfare Economics
33 Market Ensures Consumption Efficiency As all consumers face identical prices cannot manipulate prices Slope: p X /p Y Welfare Economics
34 Behavioral Assumptions: Firms Slope iso-cost line: p L /p K Given prices, firms maximize profits Welfare Economics
35 Market Ensures Production Efficiency As all firms Face identical prices Cannot manipulate prices Slope: p L /p K Welfare Economics
36 Product Mix Efficiency Brings together consumer and producer production Slope: p X /p Y As consumers and firms face identical prices cannot manipulate prices Welfare Economics
37 Fundamental Welfare Theorems First Theorem Every competitive equilibrium is an Pareto-efficient allocation Second Theorem Every Pareto-efficient allocation can be obtained with an competitive equilibrium (using Lump-sum transfers) Welfare Economics
38 Outline So far Basic model Economic Efficiency Optimality Market Economy Partial Equilibrium Analysis Summary Welfare Economics
39 General Equilibrium is costly General equilibrium approach Pro: Very comprehensive Con: Very difficult Partial equilibrium approach Consider only subset of commodities (often just one) Ignore income link Welfare Economics
40 Social Planner Basic model components: Benefit (concave) e.g., higher utility Cost (convex) e.g., production cost Net-benefit Welfare Economics
41 Social planner: Maximize Net-Benefit Efficiency condition Marginal Benefit = Marginal Cost NB Welfare Economics
42 Market Ensures Efficiency Demand function (D) equal to marginal benefit function expresses willingness to pay NB Supply function (S) equal to marginal cost function Market outcome CS PS Welfare Economics
43 Distribution of Net-Benefit Market solution distributes net-benefit (social surplus) NB Consumer surplus (CS) Difference between maximum willingness to pay and price paid Producer surplus (PS) Difference between price obtained and marginal cost CS PS Welfare Economics
44 Outline So far Basic model Economic Efficiency Optimality Market Economy Partial Equilibrium Analysis Summary Welfare Economics
45 General approach Social planner solution Choose allocation directly Serves as reference case Market solution Agents interact on markets given commodity prices General question Can market achieve social planner solution? If not, how to regulate markets? Welfare Economics
46 How do we evaluate allocations? Efficiency and optimality An allocation is pareto-efficient (or simply efficient) if it is not possible to make one individual better off without making another worse off. Efficiency makes no distributional statement Use welfare function to determine optimal allocation in terms of distribution Welfare Economics
47 Can Markets guarantee Efficiency? First Welfare Theorem Every competitive equilibrium is an Pareto-efficient allocation Assumptions Private commodities No externalities Property rights assigned Markets for all commodities Perfect information Perfect competition Welfare Economics
48 But: This is an idealized world Public goods (e.g. air quality) Non-rival in consumption Non-excludability Externalities (e.g. pollution) Individuals utility depends on other individuals consumption General question What happens if we relax our assumptions? Do we have to regulate? How? Welfare Economics
49 Questions? Welfare Economics
50 Literature Perman R., Y. Ma, J. McGilvray, and M. Common (2003): Natural Resource and Environmental Economics. Chapter 4 (Chapter 5 in 3rd edition). Welfare Economics
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