The evaluation of a public program often entails balancing its consequences for economic efficiency and for the

distribution of income. Equity and efficiency trade-off is debated in several cases. First, there is disagreement about the nature of the trade-off. To reduce inequality how much efficiency do we have to give up?. Second, on the relative value to be assigned to a decrease in inequality compared to a decrease in efficiency. Consider, a simple economy with two individuals Adam and John, also assume initially that Adam has ten oranges while John has only two oranges, an inequitable economy. Assume the role of government, and attempt to transfer four oranges from Adam to John but in the process one orange is lost Adam ending with six oranges and John with five. Mostly inequity almost eliminated but in the process total number of oranges available has been reduced. There is a trade-off between efficiency the total number of oranges available and equity. Some claims that inequality is the central problem of the society and society should simply minimize the extent of inequality regardless of the consequences to the efficiency on the other hand others claims that efficiency is the central problem. The opportunity set is defined by the consumers budget constraints and the consumers preferences by the indifference curve , the individual chooses the point on the budget constraint

which is tangent to an indifference curve this puts him/her on the highest indifference curve feasible, given the budget constraint. It gives the highest levels of utility, welfare, attainable by one individual, given the level of utility attained by others that is utility possibility curve an economy is Pareto efficient if and only if it is operating along it. Fundamental theorems of welfare economics, first says a competitive economies are always on the utility possibilities schedule and the second, every point o the utility possibility schedule can be attained through a competitive market process if the government redistributes initial endowments accordingly. Social indifference curves describes how society might make trade-offs between utility levels of different individuals. Consider the diagram below, Assume equilibrium is at point A, suppose the society decides to move say to B along utility possibility curve, increase in Johns utility and reduction in Adams utility. An increase in Johns utility from U J0 to UJ1 and the decrease in Adams utility from UA0 to UA0 answers the first question, the nature of trade-off, that is there is inversely relation, increase in one decreases the other and vice versa. The slope of the social indifference curves gives the trade-off for which is tangent to the utility possibility curve, and lies on a higher indifference curve than S0. Point B is therefore preferred by the society and answers the question of how society evaluates the trade-offs. John

Adam

Distribution

Consider the figure above, Assuming economy lies at point A, Adam enjoying more utility than John. Moving up and to the left along the schedule increases Johns utility and decreases Adams utility. Suppose, moving two steps from A to C this makes Adam more worse off. As shown in the figure the decrease in Adams utility is smaller in comparison to the increases in Johns utility. The extra utility, orange, John gets from an extra orange is called Marginal utility. Again, consider the panels below, at each point, marginal utility is the slope of the utility function that is the change in utility from a unit change in orange consumption. As more oranges consumed, utility rises more slowly, and marginal utility

falls. Thus the slope at C is less than slope at A or B. Because John is enjoys the first orange very much, and little less and less as additional orange consumed. As an individual consumes more of any good the extra gain from having one extra unit of that commodity becomes smaller that is diminishing marginal utility. Consequently, as one orange is taken away from Adam his utility decreases and as more and more oranges taken away the extra utility he loses from additional loss of orange increases. Panel A Panel B

Efficiency Efficiency another determinant of the shape of utility possibility schedule with which we can transfer resources from one individual to another. One way to transfer resources from one group to another, say rich to poor, is by taxing the rich and subsidizing the poor and this always interferes economic efficiency. The rich may work less hard than they used to work because they reap only a fraction of the returns to their effort, while the poor may work less harder because by working hard they may lose eligibility for benefits.

The magnitude of disincentives affects the entire shape of the utility possibilities as shown above. The dotted line represents the utility possibilities schedule assuming that is costless to transfer resources and the heavy line , lying far below the dotted except at point C the point which occurs without any redistribution represents the schedule when transfers are costly. An indifference curve gives those combinations of goods which give the individual the same level of utility. The social welfare function gives the level of social welfare corresponding to a particular set of level of utility attained by members of the society hence social indifference curve is the set of combinations of utility of different individual (or groups of individuals) that yields equal levels of welfare to society in other words, the social welfare function has the same value. The social welfare function provides a basis for ranking any allocation of resources we choose those allocations which yields higher levels of social welfare. The Pareto principle advices we should prefer those allocations in which at least some individuals are better-off and no one is worse-off, it says if some individuals utility is increased and no one elses utility is decreased social welfare increases. Unfortunately, most choices involves trade-offs. Consider the diagram below, at point B the second group is better off at A but the first group is worse off. The social indifference curve provide a better diagrammatic way o thinking about the trade-offs society

faces. All combinations of utilities of group 1 and 2 that are on the social indifference curve labeled W2 yield a higher level of social welfare than those combinations on the curve labeled W 1. This shows B is preferred to A. Those combinations to north east of A make every one better off and hence satisfy the Pareto Principle.

If the society is very concerned with inequality, it might not care that Adam has to give up 7 oranges for John to get 1 orange, so long as John is poorer than Adam, any sacrifice on Adams part that makes John better off would be justified. On the other hand, society might not care at all about inequality, it could value an orange in the hands of John exactly the same as an orange in the hands of Adam even though John is much poorer. In this case it would focus only on efficiency, on the number of oranges available. No redistribution of oranges from Adam to John would be justified if, in progress, a single orange was lost. Utilitarianism social welfare functions and associated social indifference curve can take variety of shapes. Utilitarians, argues that society should maximize the sum of the utilities of its members in our simple example assume two individuals, the social welfare will be W = U 1 + U2

With utilitarian social welfare function, society is not indifferent to an increase of one orange for individual 1 and a decrease in one for individual 2. If individual 1 has a lower level of income (fewer oranges) than individual 2, then the increase in utility of individual 1 from one more orange will be greater than the decrease in utility for individuals 2. What the utilitarian social welfare function says is that the utility of individual should be weighted equally to the utility of any other individual. Society should be willing to accept a decrease in the utility of the poor only if there is much larger increase in the utility of the rich. In panel A the social indifference curve is straight line implying that no matter what the level of utility of Adam and John, society is willing to trade off one unit of Johns unit utility against one unit of Adam. Panel A Panel B

In panel B, where it appears not as a straight line but as curved one as poorer individuals becomes worse and worse off the increment in utility of the richer individual that makes the society indifferent must be larger and larger i.e. slope of the social indifference curve becomes steeper and steeper. Rawlsian Social Welfare function , John Rawls , argues that welfare of the society only depends on the welfare of the worst-off

individuals, society is better if you improve his welfare but gains nothing from improving the welfare of others better ones. W = Min(U1.Un) There is no trade-off in his view. If John is worse-off than Adam, then anything that increases John welfare increases social welfare. As oranges are transferred from Adam to John it makes no difference how many are lost in the process inefficiency, so long as John gets something. In other words, no amount of increase in the welfare of the better off individual for a decrease in the welfare of the worst off individual, diagrammatically

Rawls maintains that no amount of increase in the welfare of the rich man can compensate for a decrease in the welfare of the poor. Concept of social welfare functions and the utility possibilities curve, they have been useful tools to Public sector economists but have been also extensively criticized on several grounds, Interpersonal comparison Assumption is that when an individual consumes more utility rises, but we cannot measure the level of utility or the change in utility. Also we cannot find the

meaningful way of comparing the utility of different individuals. Assuming that somehow we can compare in numerical meaningful way their level of utility like utilitarians but when we transfer an orange from Adam to John how can we compare in an objective way the value of Johns gain and Adam loss? as in the Rawlsian social welfare function, the same problem, where we are told to maximize the welfare o the worst off, we must somehow compare utilities. Also the very nature of social welfare functions . Individual have preferences, they can decide whether they prefer some combination of apples and oranges to another combination. Society consists of many individuals but society itself does not have preferences. We can describes the preferences of each individual, but whose preference does the social social welfare represents? If there were a dictator amount the answer to that question would be easy the social welfare would reflect the preferences of the dictator, but in , a democratic society there is n easy answers to the question. Some individuals- the rich, there is no may care little for while others the poorer may agree on redistribution.

REFERENCES

Stiglitz J.E,(2000), Economics of the Public Sector, 3 rd Edition Norton, New York. Holley H.U, (2003), Public Finance: In theory & Practice,Thomsom, South Western, India.

ST.AUGUSTINE UNIVERSITY OF TANZANIA FACULTY OF SOCIAL SCIENCES

DEPARTMENT OF ECONOMICS MASTERS OF ARTS IN ECONOMICS PUBLIC FINANCE 1 INDIVIDUAL ASSIGNMENT

Fundamentals of Welfare Economics Efficiency and Distribution Trade -offs

SUBMITTED TO: Dr. Nyambega 24RD April, 2013. CANDIDATE NUMBER SONYI AMANI 40594 MAEC REGISTRATION