Chapter 15 Welfare economics David Begg Stanley Fischer

Chapter 15 Welfare economics David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 9 th Edition, Mc. Graw-Hill, 2008 Power. Point presentation by Alex Tackie and Damian Ward ©The Mc. Graw-Hill Companies, 2008

Welfare economics • The branch of economics dealing with normative issues. • Its purpose is not to describe how the economy works • but to assess how well it works. ©The Mc. Graw-Hill Companies, 2008

Equity and efficiency • Horizontal equity – the identical treatment of identical people • Vertical equity – the different treatment of different people in order to reduce the consequences of their innate differences ©The Mc. Graw-Hill Companies, 2008

Pareto efficiency • An allocation is Pareto-efficient for a given set of consumer tastes, resources and technology, if it is impossible to move to another allocation which would make some people better off and nobody worse off. ©The Mc. Graw-Hill Companies, 2008

Perfect competition and Pareto efficiency • If every market in the economy is a perfectly competitive free market, the resulting equilibrium throughout the economy will be Pareto-efficient. • As expressed in Adam Smith’s notion of the Invisible Hand. ©The Mc. Graw-Hill Companies, 2008

Price of films Competitive equilibrium and Pareto -efficiency SS D P 1* D • At any output such as Q 1*, the last film must yield consumers P 1* extra utility. • The supply curve for the competitive film industry (SS) is the marginal cost of films. • Away from P 1*, Q 1*, there is a divergence between the marginal cost and the marginal benefit derived by consumers • so a move to that position makes society better off. Q 1* Quantity of films ©The Mc. Graw-Hill Companies, 2008

Market failure • … occurs when equilibrium in free • • unregulated markets will fail to achieve an efficient allocation. Imperfect competition Social priorities (e. g. equity) Externalities Other missing markets – future goods, risk, information. ©The Mc. Graw-Hill Companies, 2008

Externalities • An externality arises whenever an individual’s production or consumption decision directly affects the production or consumption of others … • other than through market prices – e. g. a chemical firm discharges waste into a lake & ruins the fishing for anglers ©The Mc. Graw-Hill Companies, 2008

Externalities • Negative Externality: Smoking, Pollution. • Positive Externality: Education ©The Mc. Graw-Hill Companies, 2008

Price A production externality Suppose DD represents the demand curve for a product (which we may interpret as marginal social benefit). D P MPC D Q Quantity MPC is the marginal private cost incurred by the firm in producing the good (assumed constant for simplicity). The market clears where MPC = DD at price P and quantity Q. ©The Mc. Graw-Hill Companies, 2008

A production externality Price MSC If the firm causes pollution, it imposes costs on society, presented by marginal social costs (MSC). So the social optimum is where DD(MSB)=MSC at Q*. Q* Q The overall welfare MPC loss to society from the market failure is DD given by the excess (MSB) of MSC over MPC between Q* and Q. Quantity ©The Mc. Graw-Hill Companies, 2008

A consumption externality E. g. neighbours may benefit from a well-kept garden. Price MPC, MSC MSB DD(MPB) Q Q' As a consequence of a consumption externality MSB>MPB, and the free market equilibrium provides the quantity Q. As compared with the social optimum at Q', where MSB = MSC. The brown area shows the welfare loss. Quantity ©The Mc. Graw-Hill Companies, 2008

Greenhouse gases ©The Mc. Graw-Hill Companies, 2008

Climate Change ©The Mc. Graw-Hill Companies, 2008

Kyoto Protocol • Began 1997 • By 2006 169 countries had signed, (not including the US) • Turkey signed in 2009. • BY 2012 emissions will be 5% lower than in 1990 • Various schemes in place including carbon trading ©The Mc. Graw-Hill Companies, 2008

Kyoto Protocol • Will End in 2012 • International Conferences for a new protocol • Copenhag 2009, Durban 2011 climate meetings • Durban 2011: Countries will form their plans until 2015 and apply it by 2020. ©The Mc. Graw-Hill Companies, 2008

Is it worth it? • Should China cut back today, to make the future better? • Stern review suggests that cuts in carbon emissions will only cost 1% of GDP per annum. • If we do not take precautions, then the cost of disasters due to the climate change are predicted to cost us 20% of the GDP. ©The Mc. Graw-Hill Companies, 2008