MSc Economic Evaluation in Health Care

WELFARE ECONOMICS
Topic 4. The Firt Theorem o! Wel!are Economic
The First Theorem of Welfare Economics
The most important and useful aspect of the Pareto Principle is the relationship between
Pareto optimality and the equilibrium of an economy in which resources are allocated by
an ideal market mechanism.
In a system of competitive markets a competitive equilibrium is a situation where a set of
relative commodity and factor prices is established such that all markets clear (i.e. the
quantity supplied equals the quantity demanded.
!iven certain conditions three important theorems can be proved. The first is that a
competitive "eneral equilibrium e#ists under the conditions stated. The ne#t two
theorems are referred to as the fundamental theorems of welfare economics and are
welfare statements about a competitive "eneral equilibrium based on the Pareto Principle$
%. The first fundamental theorem of welfare economics (the direct theorem states that
under certain assumptions a state (i.e. an allocation of "oods and factors resultin"
from a competitive equilibrium is Pareto optimal& and'
(. The second fundamental theorem of welfare economics (the converse theorem states
that under certain assumptions' every Pareto optimum state (i.e. allocation of "oods
and factors can be realised as the outcome of a competitive equilibrium "iven the
distribution of claims on income.
The first fundamental theorem of welfare economics requires$
%. Efficient e#chan"e of "oods and services (economic efficiency in an e#chan"e
economy&
(. Efficient allocation of the factors of production (economic efficiency in a production
economy& and'
). Efficient output choice (overall efficiency.
Economic efficiency in an e#chan"e economy
For simplicity' suppose an economy in which there are two consumers (households'
*lice (a and +ob (b' and there are two commodities ("ood % and "ood (.
*lice and +ob both wish to ma#imise their utility sub,ect to their bud"et constraint.
Individually' the solution to this problem requires that both *lice and +ob are on their
hi"hest attainable indifference curve "iven their bud"et constraint. This occurs at the
%
point where their indifference curves and bud"et line are tan"ential (i.e. the slope of the
indifference curve and the slope of the bud"et line are equal. This means that the
mar"inal rate of substitution (-./ between the two "oods equals their price ratio'
(p%0p(.
We can combine these two separate equilibria and construct an Edgeworth box. This is
constructed by turnin" the indifference curve map and bud"et constraint of +ob upside
down and connectin" them to those of *lice.
The dimensions of the Ed"eworth bo# are equal to the ma#imum endowments of "ood %
and "ood (. The distribution of the two "oods between *lice and +ob can be described by
any point in the Ed"eworth bo#.
The contract curve is the locus of all allocations of "ood % and "ood ( such that the
indifference curves of *lice are tan"ential to those of +ob. In other words' at each point
on the contract curve the -./ between "ood % and "ood ( (i.e. the slope of the
indifference curve for *lice is equal to that of +ob.
*t any point that is not on the contract curve' the -./ of *lice and +ob will be different.
This opens up the possibility of mutually beneficial trade$ the indifference curves reached
by *lice and +ob when they consume distributions of the two "oods not on the contract
curve form a lens1shaped area within which lie points that are Pareto superior to the
initial distribution and which can be reached by *lice and +ob if they trade quantities of
the two commodities. *t any point within this lens that is not on the contract curve there
e#ists still further Pareto1improvin" trades.
2nce *lice and +ob are on the contract curve no further improvements are possible' i.e.
one household can increase their utility only at the e#pense of the other. Therefore' any
point on the contract curve is a Pareto optimal allocation of the endowments.
-athematically this is "iven by$
3 p
3 p
-./ -./
(
%
b a
= = 4%5
In other words' a Pareto optimal allocation of two "oods across two households requires
that the mar"inal rates of substitution for each household must be equal and this must be
equal to the relative (equilibrium prices of the two "oods.
These conditions can be "eneralised to an economy with many households and "oods and
are referred to as the exchange efficiency conditions.
The e#chan"e efficiency conditions characterise the allocation of a "iven bundle of
commodities amon" the households of the economy such that it would not be possible to
(
make one household better off without makin" another household worse off (i.e. so that
Pareto optimality is achieved in e#chan"e.
We can now find the set of all aggregate endowments of "oods % and ( which can be
allocated across households to achieve that distribution of utilities or any Pareto superior
distribution of utilities. This set is called the Scitovsky set.
The /citovsky set is constructed for a particular allocation of "oods across households. In
"eneral let #
e
denote an 637 vector whose element is #
h
i is the consumption of "ood i by
household h. Therefore' in the two1person' two1"ood case discussed up until now' #
e
8
(#
a
%' #
a
(' #
b
%' #
b
(.
The boundary of the /citovsky set is called a community indifference curve (9I9' which
represents all commodity endowments that achieve an equal utility distribution on
a""re"ate in the community. Two points about 9I9s should be stressed$
%. *ll points on the 9I9 represent e#chan"e efficient allocations of the specified
a""re"ate endowment bundles& and'
(. The slope of the 9I9 is equal to the common -./ of the households at the Pareto
optimal allocation.
Economic efficiency in an production economy
For simplicity suppose there are two factors of production' labour : and capital (or
materials ; which are used to produce output of two different "oods' "ood % and "ood ('
by two firms owned by *lice (a and +ob (b. The factors of production are turned into
the two final "oods usin" the production function' which "ives the ma#imum quantity of
output that can be produced from a specified set of inputs.
The production function of a "ood can be represented dia"ramatically by an isoquant
which represents the different combinations of labour and capital needed to produce the
same level of output. (6ote that the isoquant is similar to the indifference curve which we
discussed previously.
The slope of the isoquant is called the marginal rate of technical substitution (-.T/.
The -.T/ shows the rate at which one factor of production must be substituted for
another factor of production to produce the same level of output.
-.T/ 8 slope of the isoquant at any one point 8
d;
d:

4(5
(6ote that the -.T/ is similar to the -./ which we discussed previously.
The firm is assumed to follow of "oal of profit maximisation. This means that each firm i
ma#imises profit ' where
)
i 8 pi#i < w:i < r;I 4)5
and p is the price of the "ood that the factors of production are used to produce' # is the
quantity of the "ood sold' w is the cost of labour (i.e. the wa"e rate' : is the quantity of
labour used to produce the "ood' r is the cost of capital (i.e. the interest rate and ; is the
quantity of capital used to produce the "ood.
The profit1ma#imisin" firm will seek to produce its output by methods that minimise its
costs of production. That is' the problem ma#imisation problem is analytically separable
into two sub1problems$
%. Find the cost1minimisin" combination of factors of production for producin" any
"iven output level& and'
(. Produce the output level that ma#imises profit
To find the cost1minimisin" combination of factors of production for producin" any "iven
output level' we can construct an isocost line for each firm that represents all the different
input combinations that the firm could buy by spendin" a fi#ed bud"et b on inputs. This
isocost line may be thou"ht of as a bud"et constraint for the firm and is "iven by the
e#pression$
b 8 w: = r; 4>5
The slope of the isocost line is "iven by$
/lope of isocost line 8
w
r
4?5
(6ote that the isocost line is similar to the bud"et constraint which we discussed
previously.
The cost1minimisin" factor combination for a firm facin" "iven factor prices is "iven
dia"rammatically at the point where the isoquant is tan"ential to the lowest possible
isocost line.
*t any other factor combination the costs of producin" the "iven output are hi"her (and
so costs are not minimised. Therefore' the condition for cost minimisation is that the
slope of the isoquant is equal to the slope of the isocost line' or
w
r
d;
d:
-.T/ = =
4@5
To produce the output level that ma#imises profit (the second sta"e of the firmAs
ma#imisation problem' the firm must choose an output level where the mar"inal cost of
producin" the "ood is equal to the output price' i.e'
>
pi 8 -9i 4B5
We can now analyse the equilibrium conditions for efficient production in a situation
where there are two households (firms' 4*lice (a and +ob (b5' two "oods (% and ( and
two factors of production (: and ;.
*lice and +ob both wish to ma#imise their profits. Individually' this requires that both
*lice and +ob are on their hi"hest attainable isoquant "iven their isocost line (or
similarly' that they are on the lowest attainable isocost line "iven their isoquant. This
occurs at the point where their isoquants and isocost lines are tan"ential (i.e.' the slope of
the isoquant and the slope of the isocost line are equal' which means that the mar"inal
rate of technical substitution (-./ between the two factors of production equals the
factor price ratio 4r0w5.
We can combine these two separate equilibria and construct an Ed"eworth bo#. This is
done by turnin" the isoquant map and isocost line of +ob upside down and connectin"
them to those of *lice. The dimensions of the Ed"eworth bo# are equal to the total factor
endowments owned by the households.
*ny point in the Ed"eworth bo# represents an allocation of the factors of production to
the two "oods. Efficient factor allocations are those in which it is not possible to increase
the output of one "ood without reducin" the output of the other "ood.
We can a"ain construct a contract curve which is the locus of points which are efficient.
*t any point that is not on the contract curve' the -.T/ of *lice and +ob will be
different. This opens up the possibility of mutually beneficial reallocations of the factors
of production$ the isoquants reached by *lice and +ob when they use combinations of
factors of production not on the contract curve form a lens1shaped area within which lie
points that are Pareto superior to the initial allocation and which can be reached by *lice
and +ob if they trade quantities of the two factors. *t any point within this lens that is not
on the contract curve there e#ists still further Pareto1improvin" trades.
2nce *lice and +ob are on the contract curve no further improvements are possible' i.e.'
one household can increase their output only at the e#pense of the other. Therefore' any
point on the contract curve is a Pareto optimal allocation of the factors of production.
-athematically this is "iven by$
3 w
3 r
-.T/ -.T/
b a
= =
4C5
In other words' a Pareto optimal production of two "oods across two households usin"
two factors of production requires that the mar"inal rates of technical substitution for
?
each household must be equal and this must be equal to the relative (equilibrium prices
of the two factors of production.
These conditions can be "eneralised to an economy with many factors of production and
"oods and are referred to as the production efficiency conditions.
The production efficiency conditions characterise the allocation of the economyAs factors
of production in producin" output. The economy will be producin" efficiently if factors
of production are allocated in such a way so that it is not possible to produce more of one
"ood without producin" less of another (i.e. so that Pareto optimality is achieved in
production.
*s can be seen from the contract curve a "iven endowment of factors can produce a lar"e
number of Pareto optimal output combinations. This can be translated into the production
possibilities curve (PP9 which bounds the set of all feasible output combinations that
can be produced from the "iven factor endowments.
The points on the PP9 boundary are Pareto optimal because more of one "ood cannot be
produced without producin" less of another "ood. These therefore dominate interior
points.
The slope of the PP9 is "iven by the mar"inal rate of transformation (-.T' which
represents the rate at which one "ood can be transformed into another by reallocatin" the
factors of production between the two "oods.
-.T 8 slope of the PP9 at any one point 8
%
(
d#
d#

4D5
To find the combination of outputs that ma#imises profits (the "oal of the firm we can
set up an isorevenue line that represents all the different output combinations that achieve
the same level of revenue' .. This isorevenue line is "iven by the e#pression$
. 8 p%#% = p(#( 4%E5
The slope of the isorevenue line is "iven by$
/lope of isorevenue line 8
(
%
p
p
4%%5
(6ote that the isorevenue line is similar to the bud"et constraint and isocost line which
we discussed previously.
The aim of the firm is to ma#imise their profits. Fia"rammatically this is obtained by
achievin" the hi"hest isorevenue line "iven the production possibilities determined by the
factors of production. This occurs where the PP9 is tan"ential to the hi"hest possible
isorevenue line.
@
*t any other factor point on the PP9 profits are not ma#imised. Therefore' the condition
for profit ma#imisation is that the slope of the isorevenue line is equal to the slope of the
PP9' or
-.T 8
3 p
3 p
(
%
4%(5
6ote that for this condition to hold it is necessary to be on the PP9 which in turn requires
that
3 w
3 r
-.T/ -.T/
b a
= =
4%)5
2verall efficiency
* lar"e number of allocations e#ist which satisfy both the e#chan"e efficiency and
production efficiency conditions. These can be reduced by invokin" the overall efficiency
conditions. *n allocation will be Pareto optimal overall if it is not possible to reallocate
production and distribution so as to make one person better off without makin" another
person worse off.
-any allocations are e#chan"e efficient (requirin" that allocations occur on the 9I9 and
production efficient (requirin" that production occurs on the PP9.
2verall efficiency is achieved only if the allocation is such that there does not e#ist any
feasible production possibility that is in the interior of the /citovsky set (i.e. that the 9I9
and PP9 are tan"ential.
This requires that$
-./ 8 -.T 4%>5
These are the overall efficiency conditions.
/ummary
The first fundamental theorem of welfare economics states that under certain assumptions
a state (i.e. an allocation of "oods and factors resultin" from a competitive equilibrium is
Pareto optimal. *t a competitive "eneral equilibrium there will e#ist a set of equilibrium
prices in factor and product markets such that markets clear. *ll households face the same
equilibrium prices (p%3' p(3 and' in ma#imisin" their utility' equate their -./ to the
common equilibrium prices (equation 4%5. Therefore' the e#chan"e efficiency conditions
B
are met. Profit ma#imisin" firms' which face the same equilibrium factor prices (r3' w3'
hire factors of production so as to minimise production costs by equatin" their -.T/ to
the relative equilibrium factor prices (equation 4C5. Therefore' the production efficiency
conditions are met. Finally' since households and firms face the same equilibrium prices'
the overall efficiency conditions are met (equation 4%>5.
C