First Theorem of Welfare Economics

 Pareto efficiency
• No welfare enhancing trades can be made
• It is impossible to make somebody else better off without
making somebody else worse off

 First theorem of welfare economics: the

equilibrium of a competitive market economy is
Pareto efficient if
• all goods are private
• no difference between private/social cost differences

 Formalizes Adam Smith’s concept of an invisible

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 Invisible Hand

 “Every individual … neither intends to promote

the public interest, nor knows how much he is
promoting it. He intends only his own security,
his own gain. And he is in this led by an
invisible hand to promote an end which was no
part of his intention. By pursuing his own
interest he frequently promotes that of society
more effectively than when he really intends to
promote it.”

 “It is not from the benevolence of the butcher, the

brewer, or the baker that we expect our dinner, but
from their regard to their own interest.”
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 Invisible Hand

 Idea behind invisible hand

• Societal perspective:
 A good should be produced if the “utility” to the user
exceeds the cost of producing it
• Firm perspective
 Can make a profit if the “utility” to the user (the
maximum he/she is willing to pay) exceeds the cost of
producing it

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 Key Concepts I: Private / Public Good

 Public versus private goods

• Private good
 Rival: if I eat an apple, somebody else can’t eat the
same apple
 Excludable: I can keep other people from eating my
apple

• Public good
 Non-rival: if I walk in a park, my neighbor can do so
at the same time
 Non-excludable: I can’t keep my neighbor from
walking in the park
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 Key Concepts II: Private / Social Cost

 Private costs (benefits) of an action

• accruing to the actor only

 Social costs (benefits)

• total costs of activity including those that
accrue to people other than the actor

 Example: driving a car

• Private costs: fuel, maintenance
• Social costs include pollution, road wear
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 External Effects

 Any difference between private and social

costs is referred to as an “externality” or
“external effect”

 Recall how markets work

• in seeking profits firm produce a good
 If “utility” to consumer (maximum willingness to pay)
exceeds the cost of producing it
• Problem: if private cost are different from social
cost, firm doesn’t act in societies best interest
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 Left - social cost 15, private 10
Right - private & social cost of 12

16

14

12

10
Private-Social difference
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Costs

Private
6

A B

Choices

Corporation will choose A as private cost is lower

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 Examples of Private v. Social

 Conserving tropical forests

• Private benefits: may be small for landowner
 some sales of non-timber forest products
 Eco-tourism

• Social benefits:
 carbon sequestration
 biodiversity conservation
 Etc

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 Summary

 Markets work very well when

• Assumption of first welfare theorem are met
 goods are private
 private & social costs are equal

 Less satisfactory otherwise

• “market failure” & rationale for intervention
• How best to intervene?

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 Market Failure
 Social benefits > private benefits
• Good is underprovided
• Provider has too little financial incentive, i.e.,
doesn’t capture all benefits
• Example: rainforest

 Social costs > private cost

• good is over-provided
• Provider does not account for all costs it
imposes on society
• Example: transportation, fossil fuel.
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 Policy Responses
 What to do if there is a difference between
private and social costs
• Impose a tax (or subsidy)
 equal to difference between private and social costs
• introduce of property rights
 Based on the view that an excess of social over
private costs arises from the inability to own certain
key resources, such as the atmosphere.

 Afterwards market outcome will be Pareto-

efficient again
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 Side note: Equity & Efficiency
 First welfare theorem maximizes “the size
of the pie”, but says nothing about its
distribution

 Pareto efficiency is separate from

distribution and any concept of equity.
• It states that all opportunities for mutual gain
are exploited. But not that the outcome is in any
way fair.

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 Greenhouse Gases

 Two views on CO2 emissions

• social costs of burning fuels > private costs
 Solution: impose a carbon tax.

• use of the atmosphere for waste disposal without

any payment
 atmosphere should be someone’s property
 if we want to pollute it we have to obtain their permission
and compensate them for damage to it
 Leads to tradable SO2/CO2 permits
• Requires well-defined property rights!
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 Cap & Trade Systems

 Amount to establishing property rights

in environmental assets
 Give out limited, tradable rights to carry
out an environmentally harmful activity
 Leads to mitigation banking

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 Examples of Cap -&-Trade:
 Title IV of Clean Air Act Amendments
• SO2 permit market
• Number of permits: 50% of historic emissions
• Permits are grandfathered (allocated based on
historic emissions)
• Advantage of permit market:
 Firms with lowest abatment cost will abate
 gives firm incentive to innovate
• Initial cost estimates by industry > 1000 per ton SO2
• EPA: 250-350 per ton SO2 (Phase 1)
500-700 per ton SO2 (Phase 2)
• Permit price ~150 per ton SO2
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 Examples of Cap -&-Trade:
 Fox River in Wisconsin
• Allowable firms to trade pollution rights
• Problem: each trade had to be approved
 Only 1 trade in many years

 Lessons: Permit market works best

• Clearly defined property rights
• Many potential buyers and sellers
• Low transaction cost
• Uniformly mixing pollutant
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 Examples of Cap -&-Trade:
 Wetlands banking
• www.wildlandsinc.com

 Kyoto
• Chicago Climate Exchange
• www.chicagoclimatex.com

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 Kyoto Protocol
 Cap-and-trade on emissions by industrial
countries and transitioning countries

 No significant restrictions on emissions by

developing countries
• “Clean development mechanism”
 Develop countries can get “credits” for reduction in
developing countries

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Kyoto Protocol – Annex B Countries

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Historic Emissions

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 Kyoto - targets
European Union (15 members) -8%
US -7%
Canada, Hungary, Japan, Poland -6%
Croatia -5%
New Zealand, Russian Federation, Ukraine 0%
Norway +1%
Australia +8%
Iceland +10%
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 Example: Burden-sharing agreement
(Europe)
Austria -13% Italy -6.5%
Belgium -7.5% Luxembourg -28%
Denmark -21% Netherlands -6%
Finland 0% Portugal +27%
France 0% Spain +15%
Germany -21% Sweden +4%
Greece +25% United Kingdom -12.5%
Ireland +13%
European -8%
Community

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 Kyoto Protocol

 Doesn’t tackle India-China problem:

• Large fraction of world population
 Historically low per-capita emissions
 Very few “grandfathered” permits
 Problems is not theirs but of developed world
 Could not stabilize emissions without radically new
technologies
 India / China has no incentive to join

• Without participation by China / India

 Kyoto Protocol will not come close to solving the
problem so other countries have little incentive to join.
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 An Agreement on GHGs

 Developed world
• lead in development of new technologies
• might be sufficient to bring developing countries
on board

 Clean coal technologies

• China could use all of its coal, as could India
• This would be of immense value to them.

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 An Agreement on GHGs

 China’s dilemma:
• burning coal generates terrible pollution
 domestic political issue.
• Switch away from coal will increase energy costs

 Development of clean coal technologies

• valuable to China (reduces other pollution)
• should encourage China and India to participate
in an agreement to reduce GHGs
• understanding that tight standards would only
apply once a new technology were in place.
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