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Public Finance
Fundamental Theorems of Welfare Economics/Market Failure Lecture 3, Chapter 3 (Rosen)

Fundamental Theorems of Welfare Economics

First Fundamental Theorem: A Perfectly competitive economy automatically allocates resources efficiently without the need for any centralized action (government action)i.e when it comes to providing goods and services, the free enterprise economy is very productive at allocating resources. Why?? What is the essence of perfect competition? Essence is that all individuals face the same prices each consumer is so small relative to the size of the whole market that his or her actions alone cannot affects prices. This means that Adam and Eve both pay the same prices for apples and fig leaves. Pa and Pf

From the theory of consumer choice we know that utility is maximized when: MRS Adam af= Pa/Pf MRS Eve af= Pa/Pf This gives us the original condition that we derived for Pareto efficiency i.e MRS Adam af= MRS Eve af

We must also consider the production side as well. A profit maximizing firm will produce output to a point where marginal cost and price are equal. i.e

Pa=MCa Pb= MCb Or Pa/Pb=MCa/MCb We also know that Mca/MCb= MRT Then, the condition for efficiency becomes MRT= Pa/Pb or Pa/Pb= MCa/MCb

All of these equations when considered together lead to the result

MRS Adam= MRS Eve= MRT This means that in perfect competition when all individuals seek to maximize their utility( by consuming where MRS=Pa/Pb) and firms maximize profit (by producing upto the point where P=MC), the conditions for Pareto efficiency are satisfied.

But what about Fairness?

Uptil now the only criterion we have considered is efficiency in the allocation of resources. Why have we implicitly assumed that efficiency is the only criterion for deciding whether a given allocation of resources is good? It is not obvious that Pareto efficiency by itself is desirable.

Second Fundamental Theorem

The ideal conditions of the theorems seldom hold true in the real world. For example, in the presence of either imperfect information, or incomplete markets, markets are not Pareto efficient. Thus, in most real world economies, the degree of these variations from ideal conditions must factor into policy choices. The first theorem is often taken to be an analytical confirmation of Adam Smith's "invisible hand" hypothesis, namely that competitive markets tend toward the efficient allocation of resources. The theorem supports a case for non-intervention in ideal conditions: let the markets do the work and the outcome will be Pareto efficient. However, Pareto efficiency is not necessarily the same thing as desirability; it merely indicates that no one can be made better off without someone being made worse off. There can be many possible Pareto efficient allocations of resources and not all of them may be equally desirable by society.

Lets go back to the simple model where quantities of each good were given. Compare two allocations in the Edgeworth box ( SEE FIGURE), one on the contract curve p5 (efficient but Adam gets more of each good than Eve) and the other allocation q which is not on the contract curve (inefficient but relatively more equal distribution. What allocation is preferred depends on what the society values more efficiency or equity?


Thus the criterion of Pareto efficiency on its own is not enough to rank alternative allocation of resources. Rather explicit value judgements are required to rank alternative allocations of resources.

Utility Possibilities Curve and Social Welfare Function



Contract Curve: defines a relationship for the maximum amount of utility that Adam can attain for each level of Eves utility. In figure 3.10 Eves utility is plotted on the horizontal axis and Adams utility is recorded on the vertical axis. UU is the utility possibilities curve derived from the contract curve. It shows the maximum amount of a persons utility given the other individuals utility level. Point p5 on the utility possibilities curve corresponds to point p5 on the contract curve. Here Eves utility is relatively high as compared to Adam. Because q is off the contract curve, q should be inside the utility possibilities curve reflecting the fact that it is possible to increase one persons utility without reducing the others.

All points on or below the utility possibilities curve are attainable all points above are not attainable. Because the utility possibilities curve is derived from the contract curve, all points on UU are Pareto efficient, but they represent very different distributions between Adam and Eve. Which point is preferable? That depends on the societys preferences as reflected in the Social Welfare Function.

W= F(Uadam, Ueve) Just as individual utility functions yield indifference curves, social utility functions yield social indifference curves.

Social indifference curves show how a society is willing to trade off one persons utility for another persons. Social Welfare increases as we move Northeast. Social indifference curves are downward sloping If Eves utility decreases, the only way to maintain a given level of social welfare is to increase Adams utlity. Super impose social indifference curves on the utlity possibilities curve to maximize social welfare. Point i Pareto efficient, but social welfare is higher at ii ( which is inefficient). It is even higher at point iii, which is both efficient and fair.

The First Fundamental Theorem states that a perfectly competitive economy leads to some allocation of resources on the contract curve/ utility possibilities curve. All allocations on this curve are efficient, but not all of them may be socially desirable. Government intervention may be needed to achieve a fair distribution of resources. Second Fundamental Theorem: Society can achieve any Pareto efficient allocation of resources when the government redistributes income ( eg. Through lump sum taxation) and then letting the market take over. Eg income tax vs lump sum tax Analogy: in a 100 meter race: goal is to make the runners cross the finish line together

 

 

2 ways: make them hold hands fast runners slow down waste of potential Or: move some starting blocks forward for the slow runners and some backwards for the fast runners after the race starts, each runner would be running as fast as he could, the fastest would cover the extra ground and he would end up breaking the tape neck to neck with the slowest.

Why do we need Welfare economics/Public Economics?

Free markets are not always efficient in the allocation of resources. Two main reasons why markets fail: a) market power and b)non-existence of markets

a) Market Power
First Welfare Theorem holds only if all consumers and firms are price takers. What if perfect competition does not hold and some consumers and firms are price makers? i.e they have the power to affect prices? A firm with market power is able to raise price above marginal cost by supplying less output than a competitor would. Thus, one of the necessary conditions for Pareto efficiency are violated P is not equal to MC. Eg. Monopoly, Oligopoly, firms with differentiated products (Nike, Adidas etc)

b) Non existence of Markets



The conditions for the first fundamental theorem assume that a market exists for every commodity. What if the market for a commodity does not exist? Poverty insurance? Reasons why markets might not exist: assymetric information, externality and public goods. Externality : an activity of one entity that affects the welfare of another entity in a way that is outside the market. Eg. Suppose your roommate starts smoking cigarettes which affects you negatively since it diminishes the supply of clean air for you. Your room mate consumes a scarce resource clean air, but there exists no market for clean air that forces him to pay for the air he consumes. Thus the price of clean air is zero for him, making him overuse clean air. Hence, here the price mechanism does not work in allocating resources efficiently and there is thus a need for government action.

  

What happens in the case of externalities is that marginal cost is not equal to social marginal cost. Thus the condition P=MC is not satisfied. In the cigar example, the roommates, PMC <SMC of smoking because he does not have to pay for the clean air he uses, thus, the allocation of clean air is inefficient. The price of the cigar only reflects the private marginal cost not the social marginal cost hence the allocation of resources is inefficient.

  

Public Goods: Non-Rival and Non-Excludable Non- rival: One person consumes it does not prevent others from consuming it Non-excludable: Once it gets provided, it is either very expensive or impossible to prevent others from consuming it. Examples? Lighthouse Incentive for people to hide how much they value a public good. Suppose the lighthouse is beneficial for me, but once it is built, I can enjoy its services whether I pay for it or not. Therefore I may claim that the lighthouse means nothing to me, hoping I can can a free ride without having to pay for it. Thus the market mechanism may fail to force people to reveal their preferences for public goods and thus result in insufficient resources being devoted to thme