Вы находитесь на странице: 1из 58

Efficiency and welfare

Jean-Marc Robin

Sciences Po

September 10, 2019

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 1 / 58
1. Introduction
Introduction

Recap

We saw last time that no preference aggregation mechanism is


perfect.
If we want to proceed, we need to compromise in some way.
We must abandon one of the basic principles:
Universal domain
Pareto property/Unanimity
Independence of irrelevant alternatives

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 3 / 58
Introduction

The Pareto property

The Pareto property is the criterion most closely connected to


social welfare.
If everyone can be made better off then why not do it?
So we will build on it.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 4 / 58
Introduction

Outline of this chapter

1 Introduction

2 Pareto efficiency

3 Pareto efficiency with monetary transfers

4 Kaldor-Hicks efficiency

5 Bargaining, property rights, and the Coase theorem

6 Conclusion

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 5 / 58
2. Pareto efficiency
Pareto efficiency

Pareto improvements

Definition
A Pareto improvement is any change to the economy which leaves
1 everyone at least as well off
2 someone strictly better off

Example:
You prefer $3,500 to your car
I prefer your car to $3,500
Me buying your car for $3,500 is a Pareto improvement.
Pareto improvements are “win-win”.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 7 / 58
Pareto efficiency

Pareto dominance

Definition
Alternative a Pareto dominates alternative b (or is a Pareto
improvement) if:
1 Everybody weakly prefers a to b: ∀i, a i b.
2 A least one individual strictly prefers a to b: ∃i0 such that a ≻i0 b.

Notation: ∀: “for all”, ∃: “there exists”, ∃!: “there exists only one”.
These symbols are called quantifiers.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 8 / 58
Pareto efficiency

Pareto dominance: properties

Pareto dominance defines a social ordering of alternatives.


There are no cycles (transitive). If a is a Pareto improvement over b
and b is a Pareto improvement over c, then a is a Pareto
improvement over c.
The IIA property is satisfied by definition.
The universal domain property is not satisfied because the implied
social ordering is not complete.
It could be that a does not improve over b and b does not improve
over a.
To see that consider the following example.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 9 / 58
Pareto efficiency

Example

Suppose we want to share a pie between two individuals, but we


can also throw away some of the pie.
Assume that both individuals prefer more pie to less.
Then a 50%–50% sharing Pareto dominates a 30%–50% sharing.
But 50%–50% and 30%–70% cannot be compared.

So Pareto dominance does not generally give us a clear ranking.


But when it does, it is rather compelling.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 10 / 58
Pareto efficiency

Pareto efficiency

Definition
An alternative a is Pareto efficient if no alternative b Pareto dominates
a.

We should not choose any alternative that is Pareto dominated.


This a foundational principle of economics.
Unfortunately, that still leaves us with potentially many
alternatives and no way to compare them.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 11 / 58
Pareto efficiency

Example: climate negotiations

Estimates of the effects of climate change from the Stern report


2006:
+4◦ C ⇒ −3% of GDP
+8◦ C ⇒ −11% to −20% of GDP
Estimates of costs:
1% to 2% of GDP to limit the rise to 2◦ C or 3◦ C

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 12 / 58
Pareto efficiency

Example: climate negotiations


Europe
cooperate not
cooperate (−2, −2) (−3.5, −1.5)
US
not (−1.5, −3.5) (−3, −3)

As (−2, −2) > (−3, −3) (element-wise ordering), the collective


choice (not, not) is not Pareto-efficient. Full cooperation dominates
no cooperation at all.
All other choices are Pareto-efficient. None dominates any other.
Take (not, cooperate). The US are better off than if they cooperate,
but Europe is worse-off (say because green processes are costly
and distort trade competition). So no alternative dominates.
Too many Pareto efficient alternatives.
Jean-Marc Robin Efficiency and(Sciences
welfare Po) September 10, 2019 13 / 58
Pareto efficiency

Outline

1 Introduction

2 Pareto efficiency

3 Pareto efficiency with monetary transfers

4 Kaldor-Hicks efficiency

5 Bargaining, property rights, and the Coase theorem

6 Conclusion

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 14 / 58
3. Pareto efficiency with monetary
transfers
Willingness to pay
Pareto improving monetary transfers
Utilitarian solution to the social problem
3.1. Willingness to pay
Pareto efficiency with monetary transfers Willingness to pay

Motivating example: the last soccer ticket

Consider the following social choice problem: how to allocate the


last remaining ticket for a soccer game between a set of buyers.
Suppose we can operate monetary transfers.
Thought experiment: you can choose between
1 Some money
2 The ticket
How much must we give you so that you prefer to take the money
instead of the ticket?
This is the willingness to pay.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 17 / 58
Pareto efficiency with monetary transfers Willingness to pay

Willingness to pay

Willingness to pay adds some useful information about your


preferences.
Before, we only talked about how you ranked a versus b.
Now we can say something about how much more you like a than
b.
In addition, we can compare individual preferences on a common
scale.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 18 / 58
Pareto efficiency with monetary transfers Willingness to pay

Problem: monetary exchange is not always possible

Society rejects money transactions in situations where


commodification is perceived as indecent.
Examples: organ transplant, surrogate mothers, slavery, lending
money for interest, horse meat bans in California, gambling,
prediction markets...

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 19 / 58
Pareto efficiency with monetary transfers Willingness to pay

Other problems with money

In practice, many seemingly irrelevant factors can influence the


willingness to pay of an individual.
Pricing examples that increase sales volume for common “basic”
products such as clothes and furniture:
Not showing the $ sign.
Showing a “discounted” price next to a “regular” price.
Showing two items priced the same, but one item being strictly
better.
Prices just below round numbers (say $9.99 instead of $10).
Smaller font on price tag.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 20 / 58
3.2. Pareto improving monetary transfers
Pareto efficiency with monetary transfers Pareto improving monetary transfers

Pareto dominance with money

Any allocation of the ticket is Pareto efficient in the absence of


money (in the same negative way as before).
Suppose that we were going to give the ticket to i, who has
willingness to pay vi = $100.
But j has a higher willingness to pay vj = $150.
Consider instead the following alternative:
Give the ticket to j.
Make a transfer of $125 from j to i
i and j both strictly prefer the new alternative, other individuals are
indifferent.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 22 / 58
Pareto efficiency with monetary transfers Pareto improving monetary transfers

Money transfers

We will assume that money transfers are possible and can be


enforced.
N agents
A monetary transfer scheme can be represented by t = (t1 , · · · , tN )
where ti represents the amount of money paid (ti > 0) or received
(ti < 0) by individual i.
PN
i=1 ti is the budget surplus.
P
Could be a deficit: N i=1 ti < 0
PN
If i=1 ti = 0, we say that the scheme has a balanced budget.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 23 / 58
Pareto efficiency with monetary transfers Pareto improving monetary transfers

Social choices with monetary transfers

Remember that society has to make a choice.


Now alternatives have two components:
A choice x from a set X of possible policies/allocations.
A transfer scheme t = (t1 , · · · , tN )
For example, in the game ticket example:

X = {1 gets the ticket, 2 gets the ticket, . . . , N gets the ticket }

And now, we must describe the preferences of individuals over


both components.
How do they trade off better or worse choices versus monetary
payments?

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 24 / 58
Pareto efficiency with monetary transfers Pareto improving monetary transfers

The utility function

The concept of willingness to pay is captured by a utility function.


Denote by vi (x) the value of choice x for i.
We write the utility of i from (x, t) as

Ui (x, ti ) = vi (x) − ti

(Note the dependence on t through own transfer ti .)


Then individual i prefers (x, t) to (x ′ , t ′ ) if

Ui (x, ti ) > Ui (x ′ , ti′ ).

As usual in economics, the utility function is just a mathematical


device that allows us to describe preferences in a precise way.
Let’s verify that these utility functions describe willingness to pay.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 25 / 58
Pareto efficiency with monetary transfers Pareto improving monetary transfers

Soccer ticket example

Back to the ticket example:


Choice a : you get the ticket
Choice b : I get it
Suppose you do not get any value from me seeing the game:
v(b) = 0.
You prefer getting the ticket and paying t to not getting the ticket if:

U(a, t) ≥ U(b, 0) ⇔ v(a) ≥ t

Hence you are willing to pay up to, but no more than, v(a) to get
the ticket.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 26 / 58
Pareto efficiency with monetary transfers Pareto improving monetary transfers

Willingness to pay for a couple of choices

Two choices a and b.


i prefers (a, ti ) to (b, 0) if

Ui (a, ti ) ≥ Ui (b, 0) ⇔ vi (a) − vi (b) ≥ ti

t̂i = vi (a) − vi (b) measures i’s willingness to pay in order to switch


from b to a.
This may be negative.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 27 / 58
3.3. Utilitarian solution to the social problem
Pareto efficiency with monetary transfers Utilitarian solution to the social problem

Social value

We can consider the choice x that maximizes social value:


X X
vi (x) ≥ vi (y), for all other available policies y
i i

This is called the utilitarian choice.


With willingness to pay as a measure of preference intensity, we
can now define a social welfare function.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 29 / 58
Pareto efficiency with monetary transfers Utilitarian solution to the social problem

The utilitarian Social Welfare Function


Definition
Under the utilitarian social welfare function, society prefers (x, t) to
(y, t ′ ) if
N
X N
X
Ui (x, ti ) ≥ Ui (y, ti′ ).
i=1 i=1

In particular, if t and t ′ are budget balanced, this reduces to


N
X N
X
vi (x) ≥ vi (y).
i=1 i=1

This SWF satisfies Pareto and IIA.


It is not a dictatorship as it does not satisfy Universal domain.
Jean-Marc Robin Efficiency and(Sciences
welfare Po) September 10, 2019 30 / 58
Pareto efficiency with monetary transfers Utilitarian solution to the social problem

Soccer ticket example

In the ticket example, utilitarian choice is to give the ticket to the


individual with highest WTP.
It is also the choice that maximizes total value in society.
Positive value vi for i if he is getting the ticket
0 for j 6= i.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 31 / 58
Pareto efficiency with monetary transfers Utilitarian solution to the social problem

Domain restrictions

What restrictions have we made on preferences over (x, t) pairs?


1 No monetary altruism: i does not care about tj for j 6= i
2 Paying less is preferred: ti ≤ ti′ ⇒ (x, ti ) i (x, ti′ )
3 Compensation is possible: for any x, y, there exists an amount ti
such that (x, ti ) ∼i (y, 0).
4 No wealth distortion: (x, ti ) i (y, ti′ ) ⇒ (x, ti + d ) i (y, ti′ + d ).

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 32 / 58
Pareto efficiency with monetary transfers Utilitarian solution to the social problem

Utilitarianism implies Pareto efficiency

Theorem
The utilitarian choice is Pareto efficient with monetary transfers.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 33 / 58
Pareto efficiency with monetary transfers Utilitarian solution to the social problem

Utilitarianism implies Pareto efficiency (Proof) I

Let x be the utilitarian choice, and y any other choice. Then,


N
X N
X
vi (x) > vi (y)
i=1 i=1

We will find a transfer scheme t = (t1 , · · · , tN ) such that (x, t)


Pareto dominates (y, 0).
To do so, define WTP to switch from y to x:

t̂i = vi (x) − vi (y)

This is positive for those who prefer x to y and negative for others.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 34 / 58
Pareto efficiency with monetary transfers Utilitarian solution to the social problem

Utilitarianism implies Pareto efficiency (Proof) II

Then, everyone is indifferent between (x, t̂) and (y, 0):

Ui (x, t̂) = vi (x) − t̂i


= vi (x) − [vi (x) − vi (y)]
= vi (y)
= Ui (y, 0)

Notice that t̂ has a budget surplus:


N
X N
X
t̂i = [vi (x) − vi (y)]
i=1 i=1
XN N
X
= vi (x) − vi (y) ≥ 0
i=1 i=1

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 35 / 58
Pareto efficiency with monetary transfers Utilitarian solution to the social problem

Utilitarianism implies Pareto efficiency (Proof) III

Define a new transfer scheme t by:


N
1 Xb
ti = bti − tj
N
j=1

Then t has a balanced budget and everyone strictly prefers (x, t) to


(y, 0).
Note that there are many other, non-egalitarian ways of sharing
the surplus.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 36 / 58
Pareto efficiency with monetary transfers Utilitarian solution to the social problem

Pareto efficiency implies Utilitarianism

The converse is also true when we consider only budget balanced


transfers.
Theorem
When money transfers are possible and restricted to be budget balanced, if
(x, t) is Pareto efficient, then x is the utilitarian choice.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 37 / 58
Pareto efficiency with monetary transfers Utilitarian solution to the social problem

Pareto efficiency implies Utilitarianism (Proof)

Suppose (y, t ′ ) Pareto dominates (x, t). Then:

vi (y) − ti′ ≥ vi (x) − ti

for all i, strictly for some


Hence
X X X X
vi (y) − ti′ > vi (x) − ti
i i i i
| {z } | {z }
=0 =0

Explanation: if a ≥ b and a′ > b′ , then a + b > a′ + b′ .

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 38 / 58
Pareto efficiency with monetary transfers Utilitarian solution to the social problem

Outline

1 Introduction

2 Pareto efficiency

3 Pareto efficiency with monetary transfers

4 Kaldor-Hicks efficiency

5 Bargaining, property rights, and the Coase theorem

6 Conclusion

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 39 / 58
4. Kaldor-Hicks efficiency
Kaldor-Hicks efficiency

Kaldor-Hicks improvements

A Kaldor-Hicks improvement is any change in the economy which


increases the total value available to everyone in the economy.
An outcome is a KH improvement if those that are made better off
could in principle compensate those that are made worse off, so
that a Pareto improving outcome could (though does not have to)
be achieved.
We do not require that the monetary transfer be effectively
applied.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 41 / 58
Kaldor-Hicks efficiency

Kaldor-Hicks efficiency

A Kaldor-Hicks efficient outcome is one that cannot be KH


improved.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 42 / 58
Kaldor-Hicks efficiency

Kaldor-Hicks efficiency

Unlike a Pareto improvement, a KH improvement can make some


losers and some winners.
... as long as winners gain more than losers.
We can think of it as net creation of value.
A change in the economy is a KH improvement if it can be turned
into a Pareto improvement with some redistributive (budget
balanced) monetary transfers
Hence, a KH improvement is a potential Pareto improvement.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 43 / 58
Kaldor-Hicks efficiency

Example: Free trade agreements

Standard economics implies that freeing trade is “efficient”.


What is meant is that it is a KH improvement.
Freeing trade usually makes some winners (consumers who get
better prices and more diverse goods, some producers and workers
with a comparative advantage) and some losers (workers who lose
their job, and producers who face more competition) within a
country.
What standard economics implies is that winners gain more than
losers lose.
But for free trade to be a Pareto improvement, the gains must be
redistributed so as to compensate those who lose.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 44 / 58
Kaldor-Hicks efficiency

Outline

1 Introduction

2 Pareto efficiency

3 Pareto efficiency with monetary transfers

4 Kaldor-Hicks efficiency

5 Bargaining, property rights, and the Coase theorem

6 Conclusion

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 45 / 58
5. Bargaining, property rights, and the
Coase theorem
Bargaining, property rights, and the Coase theorem

Bargaining problem

Example: Your car is worth $3,000 to you and $4,000 to me.


I have $10,000 income.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 47 / 58
Bargaining, property rights, and the Coase theorem

Threat points (or reservation values, or outside options)

$10,000 is my threat-point: the payoff I can get on my own if we


do not come to an agreement.
$3,000 is your threat-point.
Every outcome we agree on must make each of us at least as well
off as our threat-point.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 48 / 58
Bargaining, property rights, and the Coase theorem

Gains from trade

If I don’t buy the car (status quo) we get our threat points:
me, $10,000
you, $3,000
Combined payoffs: $10, 000 + $3, 000 = $13, 000
If I buy the car at some price P:
Me: $10, 000 + $4, 000 − P
You: P
Combined: $14,000
How much do we gain by cooperating:
$14, 000 − $13, 000 = $1, 000

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 49 / 58
Bargaining, property rights, and the Coase theorem

Bargaining solution(s)

Suppose we split the gains from trade equally.


We each get our threat point + $500
$10,500 for me, $3,500 for you
That means a price of $3,500.
Now all exchanges at any P such that 3000 ≤ P ≤ 4000 are better
than the status quo.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 50 / 58
Bargaining, property rights, and the Coase theorem

The Coase Theorem

Ronald Coase (1960), “The Problem of Social Cost”


Assumptions:
No (or small) transaction costs (i.e. no impediment to negotiation or
frictions),
Property rights are well-defined and tradable,
Then,
voluntary negotiations will lead to efficiency,
and the initial allocation of rights does not matter for efficiency.
The Coase theorem is important for the economics of regulation
(externalities) and has been used by jurists to resolve legal disputes.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 51 / 58
Bargaining, property rights, and the Coase theorem

Example: the rancher and the farmer

The rancher’s cattle will occasionally stray onto the farmer’s land and
damage some of the crops

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 52 / 58
Bargaining, property rights, and the Coase theorem

Rancher’s vs farmer’s rights

English Common Law: “closed range” or “fencing-in” (or farmer’s


rights)
Ranchers have responsibility to control their cattle
Ranchers must pay for any damage done by his herd
Much of the U.S. at various times: “open range” or “fencing-out” (or
rancher’s rights)
Rancher can let his cattle roam free
Not liable for damage to farmer’s crop (unless farmer had a good
fence and they broke through anyway).

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 53 / 58
Bargaining, property rights, and the Coase theorem

Coase: either law will lead to efficiency

If it’s cheaper for the farmer to protect his crop than for the
rancher to control his cattle
Under open range, the farmer will build a fence
Under closed range, the rancher can pay the farmer to build a fence
If a smaller herd is more efficient, the farmer can pay the rancher to
keep fewer cattle.
Coase:
Whatever is the efficient combination of cattle, crop, fences etc.
...farmer and rancher will negotiate to that efficient combination
regardless of which law is in place
...as long as the rights are well defined and tradable and there are no
transaction costs.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 54 / 58
Bargaining, property rights, and the Coase theorem

Rancher and farmer example with numbers

Three possibilities:
Rancher builds fence around cattle, costs $400
Farmer builds fence around crop, costs $200
Do nothing and live with damage
If expected crop damage is $100
Open range: farmer does nothing and lives with damage
Closed range: rancher does nothing and pays for damage
If expected crop damage is $500
Open range: farmer builds a fence.
Closed Range: rancher pays farmer to build a fence.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 55 / 58
Bargaining, property rights, and the Coase theorem

Efficiency and distribution

Whatever the Law, the outcome is the same (status quo or a fence
is built around the farm).
However, payoffs differ as the Law will determine different ways of
sharing the gains of trade.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 56 / 58
6. Conclusion
Conclusion

Conclusion

In the rest of the course, we will continue without universal domain


and we will maintain Pareto efficiency as our main criterion.
Then, Pareto efficiency is equivalent to a form of utilitarianism, and
this provides us with a welfare criterion over possible choices.
The Coase theorem assumes that individuals that freely bargain
together will reach an efficient solution in the absence of
transaction costs. So there is no need to design an institution
(other than well defined and enforceable property rights) to help
agents reach an efficient agreement.
When transaction costs/frictions exist, there is scope for
institution design to alleviate their effect.

Jean-Marc Robin Efficiency and(Sciences


welfare Po) September 10, 2019 58 / 58

Вам также может понравиться