Framework for Comparative Case Study: Welfare Economics

1. Framework for Comparative Case Study: Welfare Economics Gabriel M. Telleria Policy Analysis and Program Evaluation Spring 2008 Virginia Tech

2. The Welfare Economics Approach • What is welfare Economics? • Branch of economics that examines resource allocation and the policies that govern this allocation in terms of societal and/or individual costs and benefits. • One of its objective is to help society make better decisions that maximize its well-being. • Treats values as prices • Cost-benefit (cost effectiveness) type of analysis

3. Welfare economics aims to answer … • Is an allocation of resources economically efficient? • Is it equitable? (fair) • Is it feasible? • Is it desirable? • What effect does a particular resource allocation have on different groups?

4. Framework for Comparative Scrutiny • Givens • Contents • Practical Usefulness • Perspective

5. Givens: Welfare Economics • Positive vs. Normative Economics • The New Welfare Economics • Neoclassical Microeconomic Theory

6. Positive vs. Normative • Positive economics approach • Analysis based on axioms and observable behavior. • What “is” • Normative Economics • Value judgments in the analysis of resource allocation. • What “should be.” • Welfare economics tends to fall under normative economics in terms of analysis.

7. The New Welfare Economics Approach • Pareto, Hicks, Kaldor • Differentiates between efficiency and distribution • Pareto efficiency (optimality) • Kaldor-Hicks Compensation tests • Ordinal utility (ranking of commodity bundles using indifference curves)

8. The Neoclassical Approach • Edgeworth, Sidgwick, Marshall, Pigou • Fundamental Assumptions • Utility is cardinal (scale-measurable) • All individuals have comparable utility functions • Diminishing marginal utility • Social welfare function = sum of all individual welfare functions.

9. Contents • How do we measure welfare? • Consumer & producer surplus • Pareto optimality • The Edgeworth Box • Methodological Principles • 1st and 2nd fundamental theorems of welfare • The social welfare function • Market failure • Empirical content

10. How do we measure welfare? • Consumer Surplus • Willingness to pay (WTP) • Producer surplus • Willingness to “sell” (WTS) • Pareto optimality (efficiency) • Social Welfare Function • The Edgeworth Box

11. Consumer Surplus (WTP) • Individual consumer surplus = net gain from the purchase of a good • Equivalent to the difference between the maximum price a consumer is willing to pay for a good and the actual price paid • Total consumer surplus = the sum of all consumer surpluses gained by all buyers of a good in the market

12. Consumer surplus = the area above the price and below the demand curve 100 Consumer Surplus 35 P = 35 D 0 400

13. What happens to consumer surplus when the price of a good/service increases? 100 Consumer Surplus 60 P = 60 35 D 0 270 400

14. Producer Surplus (WTS) • Producer surplus is the difference between the (market) price a seller actually receives and his/her (seller’s) cost. • A seller would not sell below his/her cost • If the market price is below a seller’s cost the seller will leave the market • Does this always happen?

15. Producer Surplus and The Market Supply P S 60 P = 60 Producer Surplus 10 0 270

16. Total Surplus S 100 Consumer Surplus 60 Producer Surplus 10 D 270 0

17. Pareto Optimality • A resource allocation is said to be Pareto optimal if there is no reallocation of resources that can make one person better-off with out harming some other person. • Pareto optimality usually is the preferred criterion for economist when practicing normative economics. • A Pareto improvement is said to exist if you can reallocate resources and make at least one person better-off without harming any other person.

18. Pareto Optimality Consumer B Consumer A x2 x2 UB’ UA’ UB UA x1 x1

19. The Edgeworth Box • Allows you to represent two consumers and there decisions in a single graph. • It represents two different consumers’ consumption of two different goods and the corresponding utility of each.

20. Edgeworth Box Example x2A Consumer B OB x1B UB UA x1A OA x2B Consumer A

21. Edgeworth Box and Pareto • Suppose Consumer A and B can consume wheat and guns. • Consumer A and B’s initial allocations are endowment 1. • Let UA and UB represent respectively A and B’s initial indifference curves that intersect with endowment 1. • Can either be made better-off through reallocation of goods?

22. Edgeworth Box and Pareto Cont. WheatA Consumer B GunsB 15 OB UB 20 • Endowment 1 180 • Endowment 2 Contract Curve • Endowment 3 UA GunsA OA 5 WheatB Consumer A

23. Edgeworth Box and Pareto Cont. • Endowment 1represents a Pareto dominated allocation. • Endowment 2represents a Pareto improvement allocation. • Endowment 3represents a Pareto optimum allocation. • The Contract Curverepresents all of the Pareto optimal allocations.

24. Methodological Principles • 1st Fundamental Theorem of Welfare: • Under the competitive setting, market economies will achieve a Pareto optimal point as long as consumers maximize utility and producers maximize profits. • Associated with “efficiency” aspect of Welfare distribution.

25. Methodological Principles • 2nd Fundamental Theorem of Welfare: • Society can attain any Pareto efficient allocation by suitably redistributing income (or initial resources) and letting people trade freely until the efficient allocation is reached. • Associated with the “fairness” aspect of welfare distribution.

26. Practical Usefulness • Policy applicability • A useful tool for policy (but with certain limits) • Efficiency vs. fairness • Are all individuals the same? (in terms of utility) • Intangible costs or benefits • Treatment of policy (political actors) • Evaluation of only predetermined set of policy options • Problem-solving adequacy • Effective cost-benefit analysis tool (in some cases) • Progressing or degenerating capabilities • Progress with regards to distributional equity. • NOT THE CASE with political aspects of policy adoption

27. Perspective • Time • Forward looking (consideration of a set of policy alternatives) • Backward looking (evaluating past performance) • Policy environment is viewed as static. • Discounting favors the present (adequate discount rate?) • Audience • Public officials • Normative Stance • Accepts the distributive status quo as “just” • Treats policy and politics in mere instrumental terms • Political health and survival • Treatment of Conflicting Values • Reduces all values in terms of economic efficiency in monetary terms. • Choices are seen as technical rather than political

28. Our case study: Smoke Valley Welfare Economics • Problem: What is the optimal air pollution control policy for Smoke Valley? • Analysis limited to policy options pertaining to industrial point source pollution. • Addressing only two types of policies

29. Policy Type A: Regulatory Status Quo for Point Sources • A Cost-benefit analysis • Need to interpret air pollution in terms of its impact on well being • Amenity of clean air and health of individuals • Monetary assessment of future benefits

30. Policy Type B: System of Standards and Charges • Whatever level of abatement, this type is policy is the least-cost way. • Decisions in the hands of enterprises rather than regulators • Assumption that managers are better informed (equipped) to make decisions regarding their most efficient level of pollution. • Creation of proper incentives for polluters • Lower administrative costs (no time consuming case by case battles)

31. Results of the Study • Policy type B (System of Standards and Charges) recommended by team. • Recommendation receives mixed reviews • Trial and error system of determining optimal pollution level unsatisfactory. • Burden of cleanup concentrated on the efficient polluters • Low income residents argue abatement does not favor them. • System is a moral equivalent of a “license to pollute” • Long-term ecological effects • EPA regards study as a threat to its regulatory authority.

32. What happened? • Market failure • Nonexistence of markets • The political consideration • Information failure (asymmetric information) • Externalities (both present and future) • Public goods • Who should bear the burden? • Morality • Who decides morality? • The proper role of government • Should “bads” be a market good?

33. Questions or comments? • Thank you.