Welfare Economics Externalities Debate over Marshalls concept of

Welfare Economics: Externalities • Debate over Marshall’s concept of external economies and diseconomies—what is a genuine externality? • Pigou extended Marshall’s concept to all divergences between private costs and benefits and social costs and benefits • Many costs not included in private decisions • Externalities are grounds for government intervention

Externalities • Example of the two roads – Road 1 poor quality but wide – Road 2 high quality but narrow – Road 2 increasing cost conditions due to congestion – Private users equate private costs but do not consider costs imposed on other users – Congestion externality justifies tax on use of the better road • Knight’s critique of Pigou— externality caused by absence of private property rights

Externalities • Pigou’s example of damage to crops caused by sparks from railway engines (steam) • Coase’s later (1960) criticism of Pigou – If transactions costs are zero parties will negotiate – If transactions cost are high the right should be allocated so as to max the value of output

Pareto and Welfare Optima • General Equilibrium Approach • Ordinal utility and no interpersonal comparisons of utility • Pareto improvement—make at least one person better off and no one worse off • Pareto Optimum—cannot move without making at least one person worse off

Conditions for a Pareto Optimum • Formalization of the conditions for a Pareto optimum done in the 1930 s by Hicks, Lerner, Bergson, Lange. • Optimum condition in exchange: MRS between any pair of goods must be the same for all households that consume both • Optimum condition in production: MRTS between any pair of factors must be the same for any firm that uses both

Pareto Optimality • Optimum condition for composition of output: MRT between any pair of goods must equal the MRS between them in households y Slope of the production poss curve is the MRT = ratio of marginal costs x

Pareto Optimality and Competition • Competitive equilibrium will lead to a Pareto Optimum • First Theorem of Welfare Economics • This assumes no externalities, public goods, or common property • If all consumers are price takers then the MRS between any pair of goods will be the same for all households (utility max)

Pareto Optimality and Competition • If all firms are price takers then the MRTS between any pair of factors will be the same for all firms (cost min) • If all output markets are competitive then prices will equal MC of production: MRT = the ratio of marginal costs = the ratio of prices = MRS

Pareto Optimality I x 4 y 5 3 2 1 2 4 1 3 y 5 x II Contract curve or efficiency locus

Debates In Welfare Economics • The adequacy of Pareto criteria – No unique optimum, will depend on initial endowments – The utility possibility frontier and the limits of the Pareto UI criteria b a c d UII

Debates in Welfare Economics • Concept of Potential Pareto Improvements • Compensation Criteria • Does compensation have to be paid? • A. Bergson and social welfare functions (1938) • Arrow and the Impossibility Theorem (1950 s)

Debates in Welfare Economics • The Socialist Planning Debate – Is competition necessary for Pareto optimum? – Could a planner achieve the Pareto conditions • Socialist planning – Barone 1908, Lange 1938 • Criticism of socialist planning – Mises and Hayek: based on the ideas of the information produced by markets and the role of the entrepreneur

Neoclassical Revival • 1920 s and “Empty Economic Boxes” debate • Developments in the 1930 s – Demand Theory – Theory of Production and Cost – Welfare Economics – Theories of Imperfect Competition – Theories of money and business cycles • Neoclassicism became more than just a theory of perfect competition

Developments in Demand Theory • John Hicks Value and Capital 1939 • Built on the work of Pareto, Edgeworth, and Slutsky • Ordinal utility measure • Preference functions—the axioms of choice • Indifference curve analysis • Consumer optimum where MRS equals the price ratios • Derivation of the demand curve

Demand Theory • Income and substitution effects – Hicks definitions – Slutsky definitions • Giffen good case • Ordinary and compensated demand curves • Compensating and equivalent variations and consumer’s surplus

Theory of Production and Cost • Jacob Viner (1931) complete set of short run and long run cost curves for a firm • Viner’s famous mistake • Hicks—isoquant analysis of production functions • Cost minimization in long run where MRTS equals factor price ratios